A quality market rally
Author: Abhishek Ashok
May 21, 2019
The S&P 500 has had its best start to the year since 1986, but unlike strong rallies in the past, the climb higher in U.S. stocks through the first four months of 2019 is distinguished by one of the factors helping lead the charge.
Typically, investors expect high beta and low quality stocks to lead the market higher. While high beta stocks have been outperforming low beta stocks, high quality stocks (high ROE) have also been outperforming low quality stocks (low ROE) during this uptick.
Based on AGFiQ data, S&P 500 companies with an ROE ranking in the top quintile have outperformed those in the bottom quintile by as much as 7% over the past three months. By historical standards, this outperformance is extreme.
When the spread widens to levels such as today, however, it has almost always been followed by a period of weaker performance, whereby higher quality stocks (as defined by ROE) have not been rewarded nearly as much relative to lower quality stocks. In fact, there have been some instances, including early spring last year and in 2016, when higher quality stocks quickly reverted after a period of outperformance.
With that in mind, certain sectors may be more susceptible than others to a pullback. Almost 80% of the names in the top ROE quintile have been represented by just four sectors: Information technology, industrials, consumer discretionary and consumer staples. Of these sectors, the IT sector and Consumer Staples are most overrepresented in the top quintile.
Return on equity: S&P 500 sectors with most top quintile stocks
| Sector | % of stocks in quintile |
|---|---|
| Information technology | 25% |
| Industrials | 22% |
| Consumer discretionary | 19% |
| Consumer staples | 13% |
Real estate, energy, health care and financials have the highest percentage of stocks in the bottom quintile of return on equity with real estate and energy stocks most overrepresented in the bottom quintile.
Return on equity: S&P 500 sectors with most bottom quintile stocks
| Sector | % of stocks in quintile |
|---|---|
| Real estate | 18% |
| Energy | 15% |
| Healthcare | 14% |
| Financials | 14% |
None of this is to suggest an imminent selloff in quality U.S. stocks is near, only that outperformance in recent months of companies with strong return on equity may not be as drastic going forward. If anything, investors should continue to benefit from having some exposure to quality in a multi-factor portfolio.
Abhishek Ashok is an analyst at Highstreet Asset Management Inc. and a member of the AGFiQ quantitative investment team.
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