Investors need to take out the 'trash'
The stock market rally of the past three months has been led by weak companies like AIG, Ford and Office Depot. It's time for quality to take control.
NEW YORK (CNNMoney.com) -- Has rally fatigue finally set in on Wall Street? Stocks have been relatively flat following solid gains in March, April and May.
All of a sudden, investors are finding things to worry about again. The spike in long-term Treasury yields and oil prices has people concerned that inflation may be around the corner. And if bond rates keep rising, that could jeopardize an economic recovery.
But a pause in this rally may not necessarily be a bad thing. In fact, one is long overdue. The surge since the March 9 lows was really just a prolonged sigh of relief.
The market wasn't necessarily charging higher on hopes of a rapid and robust recovery. Instead, stocks were skyrocketing on the notion that not every big bank was going to fail or need to be nationalized. Not every retailer was destined for Chapter 11 bankruptcy or outright liquidation. The unemployment rate wasn't going to head to Depression-era levels.
This is reflected in the types of stocks that have led the market higher.
Eight of the ten best performers in the S&P 500 during the past three months are companies whose stock prices are still in the single-digits, according to Thomson Baseline. That list includes struggling retailer Office Depot (ODP, Fortune 500) and that little insurance company owned by you and me called American International Group (AIG, Fortune 500).
What's more, nine of the S&P 500's top twenty stocks since mid-March are expected to lose money in 2009, such as Ford Motor (F, Fortune 500) and beleaguered Ohio-based banks Fifth Third Bancorp (FITB, Fortune 500) and Huntington Bancshares (HBAN).
And get this, profits for the 166 stocks in the S&P 500 that are up at least 50% during the past three months are expected to decline, on average, 61% this year. Their long-term debt-to-capital ratio is, on average, 42% compared to the average of 34% for the S&P 500 as a whole.
Talkback: Are you investing in or trading stocks? If so, what types of companies are you buying right now? Leave your comments at the bottom of this story.
Simply put, the market is rewarding companies with poor fundamentals.
"Trash and junk has really rallied hard. When you look at what's done well, it's a lot of companies with weak balance sheets while quality has lagged. I definitely would not be wading into junk at these levels," said Haag Sherman, managing director of Salient Partners, an investment firm based in Houston.
Part of what's going on is just simple, good old-fashioned speculation and day trading. With the economy at least showing some signs of pulling out of what many thought was a death spiral, investors are willing to take on more risk these days.
But long-term investors need to avoid the temptation to chase performance at stocks that have had astonishing returns in the past three months since so many of these "winners" remain in financial trouble.
Just take a look at General Motors (GMGMQ). The stock has more than doubled in the week since it was delisted from the New York Stock Exchange and moved to the Pink Sheets. But with GM filing for bankruptcy, these shares will eventually be canceled. So they may make a decent short-term trade, but they're a sucker's bet for an actual investor.
Over time, stocks tend to move up and down based on corporate earnings growth -- or lack thereof. At some point, the fact that profits (or losses) aren't as awful as people expected them to be won't be enough to justify more gains.
Investors will soon need concrete proof that earnings are improving and being driven by actual increases in demand (i.e. improving sales) not cost-cutting (i.e. more layoffs) or accounting gimmicks.
Daniel Alpert, managing director with Westwood Capital, an investment bank in New York, thinks that the market will become more discerning next month -- once companies start to report second-quarter results and give guidance for the remainder of the year.
"July will be crucial. There will be less forgiveness for smaller losses. People will start wondering whether companies are actually going to post profits in the short-term," Alpert said.
Alpert's particularly concerned about what may happen to bank stocks. He does not think that many troubled banks are out of the woods just yet.
"The bank stock rally is based on the triumph of hope over fundamentals," he said. "Fundamentals are still poor and banks could face steeper losses. Commercial real estate and other loans across the board are continuing to worsen."
Now this doesn't mean that the market is going to come tumbling back to its March lows. But rather than chase the hot momentum stocks of the moment, investors might be better off looking at solid blue-chips in a wide variety of industries that are profitable, expected to post earnings growth this year and have low debt loads.
Companies like insurance broker and soon-to-be Manchester United shirt sponsor Aon (AOC, Fortune 500), biotech Cephalon (CEPH) and discount retailer Family Dollar Stores (FDO, Fortune 500) fit that bill. Those three are stocks that I pointed out in Wednesday's column as stocks left behind during the rally.
And while those three may not have enjoyed the types of eye-popping returns that some of the stress test banks have enjoyed in the past three months, they're also a lot less likely to disappoint you with massive financial losses.
Talkback: What stocks are you investing in right now? 
