Can the Low-Quality Stock Rally Continue?

Stock strategist these days seem obsessed with the concept of quality. As I wrote as early as June, the March-to-October rally was driven largely by

Stock strategist these days seem obsessed with the concept of quality.

As I wrote as early as June, the March-to-October rally was driven largely by “junk stocks.” Leading the way were smaller firms with more debt, less cash, low stock prices and falling sales. These stocks were rebounding from terrible 2008’s and their rise reflected investors’ relief that worst-case scenarios had not occurred.

But, now, market prognosticators are watching closely to see if the low-quality rally might be over. Or at least waning.

Three different views on this topic:

1. The rally may have further to run, Robert W. Baird strategist William Delwiche noted Nov. 5. But, he says, trends will moderate and not all stocks will participate. He writes of recent activity:

Small-caps have moved into a lagging position relative to large-caps, failing to match gains on the upside and leading the way lower on pullbacks.

Financial stocks look weaker to Delwiche, while energy, consumer staples and utilities are looking stronger.

2. Commentators at Bank of America Merrill Lynch, led by chief U.S. equity strategist David Bianco, focused on the concept of beta, a measure of volatility, in a Nov. 9 note:

We expect higher beta stocks in general to outperform lower beta stocks as the market grinds higher. We expect higher quality stocks to outperform lower quality stocks of equivalent beta.

But beta and quality aren’t the same things, and disentangling the two concepts can be difficult, they warn.

3. If you think the market rally has run out of steam, it may be time to move into so-called defensive stocks, firms that will hold value even if the market sinks or moves sideways.

Barclays Capital portfolio strategist Barry Knapp believes it may be too early to make any drastic moves. But, he wrote Nov. 6, “we have reached a turning point in the Fed liquidity-driven, highly-correlated rally across all asset classes.” He adds:

While it’s probably too early in the cycle to be playing defense, the valuation opportunities present in the space compel us to take a small step in that direction.

He proposes buying more defensive stocks but still favoring more economically sensitive stocks overall. For example, he believes tech, industrials and energy “should continue to outperform.”

No matter what happens, many high-quality stocks seem to be trading at prices that could be attractive to long-term investors.

In the meantime, much will depend on corporate profits in the last three months of 2009. After a long recession and financial crisis, two of the weakest sectors are consumer discretionary and financials. Both are predicted to report huge boosts in earnings early next year.

If they do so — if retailers have a better-than-expected holiday season and banks repair their balance sheets significantly — the low-quality rally just might continue.

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