This volatility-resistant area of the stock market is ripe for outperformance after two decades of decline, according to Bank of America
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- Quality stocks have been overlooked for the last two decades, but that could be about to change.
- Increased volatility will spike demand for high-quality stocks, according to Bank of America.
- Financials, real estate, dividend stocks, and equal-weighted indexes are the best areas of quality.
A cooling economy, another lackluster jobs report, impending rate cuts, and the upcoming election — with all of these factors, it's shaping up to be a choppy market environment.
And to add fuel to the fire, September is historically the worst month for stock market performance.
Before investors panic, there is some good news. According to Bank of America, one area of the market is set to benefit from increased market volatility: quality stocks, or stocks with strong business models and financial fundamentals.
And the cherry on top is that quality stocks — which typically become expensive during downturns — are still cheap despite their recent rally, coming out of a two-decade rut.
A return to quality
Savita Subramanian, the bank's head of US equity and quantitative strategy, expects to see increased demand for quality stocks as the economy and stocks remain on shaky terrain for the near future.
"Finance 101 says predictability should trade at a premium to risk," Subramanian wrote in an August 14 note.
In the note, Subramanian pointed to a few signs that the economy is slowing and that quality stocks should continue outperforming in a volatile environment despite posting already impressive performance this year.
First, the yield curve, a leading indicator of the VIX, suggests that volatility in the stock market will remain elevated for the next few years until 2027. A flat or inverted yield curve is often associated with economic slowdowns and subsequently increased volatility in the stock market.
Bank of America
The bank's Regime Indicator — which takes into account macroeconomic variables like inflation, GDP forecast, bond yields, the ISM PMI, S&P 500 earnings revisions — also declined for the second month in a row this August, officially entering downturn territory. In times of regime downturn, the bank found that high-quality, low-risk, and large-size stocks perform well.
As seen in the graph below, the high-quality factor serves as a hedge against elevated market volatility. Stocks with a B+ or above rating on the S&P 500 quality index have historically performed well against a rising VIX.
Bank of America
Quality is still cheap
Luckily for investors, this safe-haven area of the stock market is trading at an attractive valuation.
For the last two decades, low-quality stocks have been trading at premium to high quality. Near-zero interest rates and other forms of fiscal stimulus created easy money environments that encouraged risk-taking, Subramanian wrote. Hence, investors saw less need to pay up for quality.
That has started to change, and will continue to do so, Subramanian thinks. As the economy enters a downturn phase, low quality will start to lag, Subramanian believes.
Bank of America
While quality stocks have recently re-rated to a slight premium, they're still reasonably priced, according to Bank of America. Quality stocks are trading at their pre-2000 levels, which Subramanian calls "a return to normalcy."
Additionally, there are underrated areas within quality, according to Bank of America. Investors seeking quality have typically ignored cyclical growth areas in favor of defensive secular growth areas. As a result of this misperception, cyclicals are trading at disproportionately high betas, in Subramanian's opinion.
On the contrary, certain cyclicals such as financials and utilities are actually higher quality than traditional defensive picks, with lower earnings volatility. Financials currently has the highest proportion of B+ and higher quality companies, followed by staples and industrials.
Bank of America
Where to buy quality
Bank of America's top sectors for quality stocks during a downturn include financials and real estate.
The bank believes that investors are overestimating risk within these two areas. Financials lead all other sectors in terms of quality stocks. And in the last decade, the proportion of the real-estate sector's market cap that is considered quality has more than doubled, from 30% to 70%.
Other areas of quality include dividend stocks and equal-weighted indexes, according to the bank.
Companies with healthy cash flow can return capital to investors through dividends. Especially in times of economic downturn, a company's ability to continue paying dividends to investors is a good indicator of its underlying financial stability. Bank of America also points out that the equal-weight SPW index is posting more stable earnings compared to the market-cap-weighted SPX, with the SPW displaying lower earnings volatility over the last three years.
Investors can gain exposure to these areas of quality through funds such as the GMO US Quality ETF (QLTY), iShares US Financials ETF (IYF), Vanguard Real Estate ETF (VNQ), Schwab US Dividend Equity ETF (SCHD), and Invesco S&P 500 Equal Weight ETF (RSP).