Traders Seeking High-Quality Stocks Is Bearish Market Signal

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  • They eke out gains in a market where $2 trillion is erased
  • S&P 500 down 5.1% this year as defensive shares wake up

Why United States is Not Recession Bound

In the worst start for the U.S. stock market since 2009, investors have been aggressively loading up on shares of companies with the sturdiest earnings momentum. And that’s raising concerns.

Animal spirits are out as qualities that define winning investments no longer include the high-risk, high-reward potential of shares backed by debt-laden balance sheets. History shows that such a shift has been a bearish signal for stocks in the past, often marking the end of bull markets.

“It’s indicative of being in the seventh year of an economic expansion -- investors are just being cautious,” said Hank Smith, who helps manage $8 billion as chief investment officer at Haverford Trust Co. in Radnor, Pennsylvania. “If you’re an equity investor in 2016, it’s been really hard to avoid some pain.”

Defensive posturing is evident in this year’s industry leaders, with phone companies, utilities and producers of consumer staples showing the only gains through last week and commodity, bank and health-care firms falling the most. Gone from the leader board are the companies that led the way as more than $17 trillion was added to equity values since 2009: those whose finances are deemed the dodgiest by bond-ratings firms.

The Standard & Poor’s 500 Index fell less than 0.1 percent to 1,939.38 at 4 p.m. in New York.

Through Jan. 26, the best stocks to own in the U.S. were companies with the most reliable record of earnings and sales acceleration, two quantitative properties characteristic of an embrace of quality, according to Abhra Banerji, the director of quantitative research at Evercore ISI. Among them are C.H. Robinson Worldwide Inc., the Eden Prairie, Minnesota-based logistics provider, and WEC Energy Group Inc. At the other extreme are shares showing higher-than-average price volatility, a group that has lost 7.6 percent in 2016.

Stocks fitting into higher-quality buckets have taken over leadership just in time for one of the worst start to a year since 1927 -- hardly unusual. Sentiment has almost always shifted toward sturdier companies in past selloffs, with earnings trends a leading factor in 2008 and 2002, data compiled by Evercore ISI and Bloomberg show.

“In the past years when these factors have dominated strategy performance, you’ve tended to see negative returns,” said Banerji. “If this month serves as a template for the rest of the year, things are not looking good.”

Equity investment strategies focused on companies with growing profits and accelerating sales are seeing their best performance since 2008, a year where the S&P 500 slipped 38 percent, according to Evercore ISI data. They did similarly well in 2002, when the benchmark index lost more than 20 percent.

“When you have these points of panic, you do sell everything, and then you start selling less of the good stuff to cover the bad,” said Joe Quinlan, New York-based chief market strategist at U.S. Trust, which oversees $376 billion. “We’re long into this bull market in equities. You do hit these patches, particularly against a global backdrop of slower global growth and tanking oil prices, when high-quality is more appealing than anything else.”

Losses in the index have been deepest in 2016 for companies with low credit quality. Companies with bond ratings below investment grade have lost an average of 11 percent year to date, compared with 4.7 percent for higher-rated ones. Even for companies within the investment grade range -- defined as a rating of at least triple-B -- declines have extended as credit quality worsens.

The strength seen in defensive sectors this year isn’t as much a signal that market leadership is shifting as it is a reaction to swift losses, according to Jim Paulsen, the Minneapolis-based chief investment strategist at Wells Capital Management Inc., which oversees $351 billion.

Wall Street strategists remain bullish. The index will rise about 13 percent to 2,200 by the end of the year, according to the median of 19 estimates compiled by Bloomberg. The index climbed 2.5 percent Friday, the most since September.

Bank of America Corp., which shares the consensus year-end target of 2,200, predicts that the S&P 500 will overcome global headwinds and boost profitability index-wide in 2016, even with high-quality companies continuing to lead the market. That will mark a shift in leadership from earlier in the bull market that is nearing its seventh anniversary -- one that reflects a growing investor preference for safer stocks that aren’t a harbinger of pain, according to Jill Carey Hall, an equity strategist at the firm.

“The hit to corporate earnings from weak oil and the big rise in the dollar will slowly lessen,” said Hall. “Near-term we expect to see some volatility, but as the year goes on, we think profit and sales growth will start to pick up again. We’re expecting the market to go up from here, but we remain very cautious on credit-sensitive names.”

Bank of America forecasts that earnings for companies the S&P 500 will expand 5 percent in 2016. The average analyst prediction calls for 4.6 percent profit growth, according to data compiled by Bloomberg.

Should the S&P 500 reverse and end the year higher, it will probably require gains in momentum stocks that have gotten off to a rocky start in 2016. The strategy, defined as investment in the companies with the biggest gains in the last six to 12 months, was the top-performing investment method in 2015 with a 32 percent gain, according to Evercore ISI data. So far this year, an exchange-traded fund tracking the group has tumbled 7.3 percent, trailing the S&P 500 by more than two percentage points.

“You can’t leave any stone unturned, and everything is going to eventually crack,” said Walter Todd, who oversees about $1.1 billion as chief investment officer for Greenwood Capital Associates LLC in South Carolina. “Some of the only stocks holding up the index last year, these big momentum winners, are now seeing some cracks.”