Celia Dallas
Answers to our clients’ questions about market action and the market environment in a few paragraphs every two weeks.
Yes, if you control for tech overweights. Quality has historically been quite defensive relative to the broad market. Today, it is sensible to question quality’s defensive characteristics, as the factor is concentrated in tech stocks and has become quite expensive. If implemented appropriately, we believe quality will decline less than broad equities under most stress scenarios. Quality can easily be implemented in a sector-neutral fashion that eliminates a tech overweight. In addition, the factor remains reasonably priced relative to growth stocks, such that a tilt from growth to quality should add defense to portfolios.
When markets become significantly concentrated in one sector, that sector tends to underperform during the next bear market. Based on analysis of the S&P 500 Index, when sectors account for more than 20% of the index’s market capitalization they may continue to grow more concentrated, but when the next bear market arrives these winning sectors tend to be the worst performers. In other words, history suggests that tech will underperform in the next bear market, and quality strategies with tech overweights may fail to be defensive.
Today, US equities have a 27% weighting to the tech sector and quality has a 47% weighting—a 20 percentage point overweight! As a result, we have evaluated the MSCI US Sector Neutral Quality Index and find that it provides superior exposure to quality today. MSCI offers quality indexes based on characteristics that we agree represent high quality—low leverage, high return on equity, and stable earnings growth. The sector-neutral versions of their quality indexes use the same quality selection criteria, but constrain sector weights to match that of the broad market index. The MSCI US and world quality indexes were able to outperform* the broad market in the aftermath of the tech and telecom bubble, as well as during the global financial crisis; however, the overweights to tech were not as significant in these earlier periods. The sector-neutral version of quality is still concentrated, but no more so than the broad market, and was also able to outperform the broad market during these earlier bear markets.
Skilled active managers with a valuation-sensitive tilt toward quality are also a good choice, and in select cases, may offer higher potential returns than the index. The active managers we track in this sector of the market are not explicitly trying to position themselves to be defensive. They tend to be low turnover strategies that are biased to more stable, more predictable cash flow streams and remain disciplined on valuation. As such, they tend to be more defensive. To the extent investors use active managers to implement quality, this is a reasonable time to evaluate the degree to which they own sizeable allocations to tech stocks.
Even after adjusting for tech concentration, quality stock valuations are high today in absolute terms and higher in relative terms compared to the broad market than was the case ahead of the last two major bear markets, in which quality outperformed. However, quality is more reasonably priced versus growth, with a relative P/B ratio in the sixth percentile and a relative price-to–cash earnings ratio in the 43rd percentile of history since 1998. As a result, we recommend investors overweight sector-neutral quality relative to mid- to large-cap growth equities.
There is one key scenario in which high-quality stocks are quite likely to fail to be defensive. Quality stocks are very-long-duration assets and, as such, would do quite poorly in an environment of rising interest rates. In five of the last six periods since 2000, whenever the US ten-year Treasury yield increased by 100 basis points or more, the MSCI US Sector Neutral Quality Index underperformed the broad market—a worse track record than incurred by the Russell 1000® Growth Index, which underperformed the broad market in half of the last six rising rate periods. Investors should take this historical underperformance into account when sizing any overweight position in quality stocks. Should rates rise further, value stocks may be the more defensive style. Value stocks, with their hefty exposure to financials, tend to benefit from rising longer-term rates, provided the yield curve remains positively sloped—today, value is cheap enough relative to the broad market to outperform in a bear market.
* The MSCI US and world quality indexes were launched in December 2012; the sector-neutral versions were launched in December 2014. Performance assessment prior to these dates is based on backtests.
Celia Dallas, Cambridge Associates’ Chief Investment Strategist