Quality stocks are dominating the market, up 25% in the past year

Published Sat, Jan 27 20247:17 AM EST

Investors have grown a bit snobbish, insisting on buying the highest quality and willing to pay up lavishly to own and flaunt the best. Among the most broadly played investment "factors" — including value, momentum, low volatility, dividend yield — quality has dominated the market, the representative iShares MSCI USA Quality ETF (QUAL) up 25% in the past year, compared to 13% for S & P 500 value and less than 5% for the equal-weighted S & P 500. Even within industry sectors, the stocks with higher quality scores have sped ahead ( Costco in retail, WW Grainger in industrials, etc.). The quality label is based on strong balance sheets, high and steady profit margins, consistency of earnings growth and the like. The category is adjacent to and inclusive of the small group of enormous growth stocks that have led the market for a year, but it's more than just the giants of the Nasdaq. Yes, Nvidia , Microsoft and Apple are top holdings in the QUAL ETF (and numerous similar ones) but so are Visa , Mastercard , Nike and UnitedHealth . As this flavor of stock has gained favor, the S & P 500 itself has taken on more of a quality character over time, something that strategists at Bank of America and Citi have been noting for a while, as they argue index earnings are less cyclical than decades ago and perhaps deserve a higher valuation than used to be the norm. Over the past five years, note the QUAL ETF has been almost indistinguishable from the S & P 500 and from Berkshire Hathaway, a company that exemplifies financial sturdiness and quality business traits. Even this year, with investor risk appetites flowing a bit faster again, large-cap quality as a whole is ahead of the broader market, and in the first four weeks of trading has outperformed the ARK Invest strategy – a proxy for more aggressive, lower-quality stocks – by 15 percentage points. True, ARK and its ilk raced ahead in the 2023 all-in fourth-quarter rally, a tough setup into the year. But the action so far in 2024 is noteworthy as being a near-total inversion of last January, when ARK whistled higher by 25% in a massive short-covering rebound move that was roundly lamented even if it fit with how the market typically acts right after a bear-market bottom. Too much of a good thing? It might seem twisted to ask whether investors collectively are overdoing it on quality, privileging the clear fundamental long-term winners over the less advantaged. But it's worth pointing out that the premium on quality is arguably becoming extreme, as both bullish economic optimists and bearish recession heralds cluster in the proven growers protected by the widest competitive moats. The quality basket's forward price/earnings ratio is not breaking new ground in absolute terms, near 22 now, but its relative multiple is at a decade high. Something similar applies to Berkshire Hathaway, with its $157 billion in cash on hand, near-6% stake in Apple, multi-generational management team and an array of wholly owned businesses exploiting profitable niches. Enviable all around, though also near the very upper end of the stock's price-to-book-value range of the past 15 years. None of this is irrational, though even rational trends can get overdone at times. Carrying the earnings load The narrowness of the S & P 500's performance – which gave way to a two-month broadening pattern heading into 2024 that has not persisted in a clear way in recent weeks – is best explained not by AI enthusiasm or technology worship but by the contribution of the Magnificent Seven companies to overall earnings. Goldman Sachs calculates that those seven companies as a group had profit-growth forecasts for the fourth quarter revised higher by four percentage points since Sept. 30. The other 493 companies in the index together saw fourth-quarter earnings cut by 16 percentage points. And for the first quarter, FactSet says Alphabet, Amazon, Meta Platforms and Nvidia are projected as a group to report 80% earnings growth, all other companies almost no growth. All of this is about what the quality leaders have done lately, not what sorts of companies represent a better risk-reward equation now. Some disciplined investors are playing for a market less beholden to the acknowledged mega-cap winners. Michael Gates, lead portfolio manager for BlackRock's Target Allocation ETF model portfolio group, initiated a rebalancing away from the QUAL ETF and other growth vehicles areas toward value funds "to reflect a bullish view on the economy and a soft landing." This gets at the fact that the premium on quality is in large part the cost of predictability, which is essentially defensive — a way to pay up for insulation against a tough economic trajectory. Sure, there are multi-year secular growth stories animating the AI innovators and weight-loss-drug developers, but most quality stocks stand out for steadiness. For sure, there have been prior market cycles that peaked spectacularly while saturated with a blind belief that no price was too high to pay for the elite corporate winners. The Nifty Fifty period half a century ago most conspicuously, when a few dozen stocks surpassed 40-times earnings in otherwise weak market. And the late-'90s was infused with blue chip fever too in the final stretch to the year-2000 peak. Yet today, the quality trade seems favored less because investors are overconfident in the companies' eternal growth than as a default choice against a large majority of cheaper cyclical stocks in a period when a recession is always feared as imminent but has yet to arrive. Bubble yet? Last week much attention was paid to Ed Yardeni of Yardeni Research, who is bullish on stocks yet expressed a fear of irrational exuberance and a late-'90s-style bubble-like melt-up potentially emerging. Yet while the Nasdaq 100 is up almost 50% in a year, it's gained only 5% in the last 26 months. In the 18 months leading into the March 2000 peak, the Nasdaq more than tripled. In 1999 alone, there were nearly 500 IPOs, and their average first-day price gain exceeded 90%. We are now in a prolonged IPO drought and the small-cap growth indexes are flat versus three years ago. The simplest explanation for the market holding near the record highs with the S & P 500 up nearly 20% from the low exactly three months ago is that the market is priced for a pretty benign economic backdrop and we keep getting evidence of a very benign one. Big upside surprise to fourth-quarter GDP with further downside momentum in core inflation adds to the well-earned investor confidence in a macroeconomic cushion. Whether the Federal Reserve clearly signals an interest-rate cut in March next Wednesday or not, everything we know about the Fed's policy decision tree and the path of current data leads to at least modest pruning of rates into a solid economy. For sure, stocks have come a good distance and there are some signs of a short-term "mission accomplished" moment. The S & P 500 clicked exactly to 20-times forward earnings last week. Microsoft surmounted the $3 trillion market-cap threshold. Several stubborn Wall Street bears have capitulated with raised index targets to start 2024, sometimes cause for tactical concern. Any give-back of the leading quality growth names wouldn't be easily absorbed by the broader market. We could surely get a sell-the-news response on some of the Mag7 earnings reports in coming days. Or traders might overread some Jerome Powell comments as changing the premise of a friendlier Fed. And February often brings some turbulence to the tape. Yet the crowd's zeal for "quality" stocks, the impressive technical caliber of the rally, the upturn in earnings from last year's trough, overall strategist consensus calling for minimal upside from here and investor sentiment held short of hubris by constant doubt about the durability of the expansion, it's unlikely that the next wobble in the indexes would prove to be the Big One.