As Sam Sees It: Is a Flight to Quality On the Horizon?

Sam Stovall  |

Each week, we tap the insight of Sam Stovall, Chief Equity Strategist for S&P Capital IQ, for his perspective on the current market.

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EQ: While we’ve experienced a bit more volatility this year, the S&P 500 is still in the positive so far for 2014. Do you get the sense that the market still wants to go higher from here and not yet ready for a pullback?

Stovall: If I look exclusively at the S&P 500, I would agree with that statement. However, if you actually look beneath the surface you’d see the Consumer Discretionary sector, which is among the worst-performing groups, is underperforming the Consumer Staples sector, which is traditionally a defensive group. You’ll also find that Utilities are up more than 10 percent year-to-date, and see that small-cap stocks are also underperforming. I think market action below the surface is telling us that investors are looking to pull in a little bit of their risk exposure and just allowthe larger stocks to work their way higher. As a result, I would not say that I think that the pullback has been put on pause.

EQ: In this week’s Sector Watch, you stated that when the seas get rough, investors prefer a steadier boat. In a sense, you anticipate a rotation into quality over higher-risk stocks. Has that rotation started yet?

Stovall: I don’t think the rotation into quality has happened yet, but I think it will. We identify quality as consistency, consistency in raising earnings and dividends in each of the last 10 years.? Companies with a letter grade of A, A-, or A+ have had above average consistencies, whereas those with a B-, B, or C have had below average.

Right now, the low quality stocks have done much better on a year-to-date and prior 12-month basis as compared with the high quality stocks. I think this is because interest rates have been kept artificially low. As a result, however, the valuation for these low-quality stocks are at a 36-percent premium to the high quality stocks. The average P/E for low-quality stocks is 27 versus 17 for the high quality stocks. So I don’t think the rotation has started just yet, and I believe there is more upside potential for the higher quality issues.

EQ: Of the S&P 500 companies, 443 have quality rankings. Why are the other 57 unranked?

Stovall: Basically it’s because they don’t have 10 years’ worth of history of earnings or dividends. So, a company like Facebook (FB) , which is a relatively new entrant into the S&P 500 just doesn’t have a long enough track record.

EQ: There are 128 companies that are deemed as high quality according to the ranking criteria, and they’re currently trading at a 36-percent discount to the low quality stocks based on 2014 estimates. Does that mean investors are still willing to pay such a high premium for risk?

Stovall: Yes, I think so because we’re still not getting enough economic data to prove that economic growth is ready to stage a renaissance. When you’re looking especially at the housing data, it indicates that we could end up reverting more toward a stagnant economic growth. That would be a sub-par growth we’d experience since this economic expansion began in June 2009.

So I think with interest rates being historically still quite low, that investors are still willing to go pretty far out on the risk curve and not limit themselves to the lower returns that go along with the lower volatility of the higher quality stocks.

EQ: When you put it all together, it looks like the quality stocks are very attractive right now. They’re trading at a discount to the higher risk stocks, but also investors could be getting ahead of the curve a bit if a flight to quality does occur.

Stovall: That’s right. Also, since we are approaching the seasonally vulnerable period for the market, also known as the “sell in May” period of May through October, and overlay that with the worrisome mid-term election year softness that we traditionally see, then I think investors will be happy to own higher quality stocks because of their low average betas.

The average for above-average quality stocks is 0.94 versus an average beta for low-quality stocks of 1.41. So you have substantially higher volatility with the low quality stocks than you do with the high quality stocks. Obviously, we all know that the more you lose, then the more you have to earn just to get back to break even.

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