High-Quality Stocks Could Take Market Lead

Slower economic growth may be good news for stocks renowned for their resilience in tougher economic times.

This, in turn, could boost the performance of stock managers who specialize in these higher-quality, defensive names, especially in sectors such as health-care and consumer staples.

"Maybe we'll have our moment in the sun," says Scott Armiger, portfolio manager at Christiana Bank & Trust Co., who has a high concentration in consumer staples stocks.

As the stock market recovered from its decade low of Mar. 9, 2009, to its 2010 peak on Apr. 23, the Standard & Poor's 500-stock index's financial sector—beaten down by the financial crisis—rose 170 percent. The S&P 500's consumer discretionary sector, including retailers hurt by the slowdown in consumer spending, gained 124 percent.

"At the very beginning of a market upturn, the lowest-quality stocks tend to outperform," says Sean Kraus, chief investment officer at CitizensTrust. "You had a lot of [portfolio managers focused on quality] underperforming last year because they would not go" to lower-quality stocks.

are higher-quality stocks moving up?

Falling behind was the S&P 500 health-care sector, up 43.5 percent from Mar. 9, 2009 to Apr. 23, and the S&P 500 consumer staples sector, up 44 percent, even as both sectors did a better job at maintaining earnings and sales during the recession.

Worries about the economy may already be helping higher-quality stocks outperform during the last several weeks.

The Morgan Stanley Cyclical Index (which measures economically sensitive stocks in the U.S.) is down 16 percent since Apr. 23, while the Morgan Stanley Consumer Index (a gauge of less economically sensitive companies) has fallen 9.8 percent.

While the S&P 500 has slid 12.5 percent since Apr. 23, the S&P 500 consumer staples sector is down 5.1 percent—and its largest company, Procter & Gamble (PG), is off 2.4 percent.

The S&P health-care sector and its largest stock, Johnson & Johnson (JNJ), are both down 8.6 percent since Apr. 23.

health-care earnings haven't fallen

"Consumer staples and health-care stocks typically have more predictable, less volatile earnings streams," says Michael Sheldon, chief market strategist at RDM Financial Group.

According to Bloomberg data, health care is the only sector of the S&P 500 not to see quarterly earnings drop year-over-year in the past two years. The S&P 500 consumer staples sector's worst quarter, the fourth quarter of 2008, saw earnings fall 7.5 percent—as overall S&P 500 earnings were plunging 47.2 percent.

Several stock managers and strategists say that the current environment may give higher-quality sectors an advantage. "As the economic data continues to soften, we should see these better-quality names picking up steam," says Quincy Krosby, Prudential Financial (PRU) market strategist.

Federal Reserve minutes released on July 14 show that central bank officials have lowered their 2010 economic growth forecast from a range in April of 3.2 to 3.7 percent, to a range in June of 3 to 3.5 percent. Other data have supported the belief that the economy is slowing its growth rate, including a drop on July 16 of 9.5 points in the Thomson Reuters/University of Michigan preliminary index of consumer sentiment to 66.5, the lowest level in 11 months.

investment focus: leading stocks?

Still weighing on health-care stocks is the possible impact of federal health-care reform legislation that became law in March. On one hand, the law "wasn't nearly as bad as a lot of industry participants were fearing," says Morningstar (MORN) health-care stock analyst Matthew Coffina. On the other hand, the law is complex and could take years to fully enact. "Investors are on edge," Coffina says, reacting day-by-day to shifting perceptions of how regulators will implement the law.

Wayne Titche, chief investment officer at AMBS Investments, says a slower-growth economy will favor the leading stocks in many different sectors, including consumer discretionary and technology. The key, he says, is finding companies with strong balance sheets and cash flow, good management, and the ability to develop new products and gain market share.

Titche cites retailer Kohl's (KSS), which he owns. "They have the money to invest and take share from weaker players," Titche says.

A stock market that rewards quality is one that is thinking long-term, Titche says. Investors have become very short-sighted, he says. "People have totally lost faith in long-term investing."

In the past year, broad trends—from issues in the U.S. economy to the European debt crisis—have shaped the stock market. Soon, however, investors are going to have to make "stock-specific" distinctions between the strong and weak players in each industry, Krosby says. Despite "a slowdown in the economy, many stocks are going to do very well," she says.

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