Emphasize High-Quality Value in the Core

Elevated cross-asset volatility and shifting macro forces have created a more complex market environment in 2022. Sentiment has been impaired and risk-on attitudes have faded, following three consecutive years of gains and limited outsized moves in 2021.

As a result of the multiple dimensions of risks converging on top of one another, equities are down significantly this year — evidenced by 70% of global stocks trading in a bear market.¹ But the equity drawdown has not greatly improved overall valuations. Broad-based valuations are now near long-term averages based on price-to-earnings ratios, but still well above historical averages based on price-to-sales and price-to-book metrics.²

The complexity of this current environment can also be quantified by comparing current implied volatility levels; the CBOE VIX Index has averaged 25.7 in 2022, versus its long-term average of 19.5.³ And the average percentile rank for measures of implied equity, as well as bond, currency, and oil volatility, are all above the 80^th percentile — reinforcing how widespread risks have become.⁴

But with earnings sentiment waning, as evidenced by upgrade/downgrade trends, fundamental volatility has picked up — making firms’ cash flow strength extremely important for performance.

Adding fundamental risk to multiple macro risks, requires placing greater emphasis on attractively valued firms that exhibit lower relative fundamental volatility. These quality firms that offer more durable balance sheets with little leverage and low earnings growth variability may be well positioned for more consistent growth.

Adjust to a Complex New Volatility Regime

Realized volatility metrics further illustrate this complex risk regime. For example, the S&P 500 Index has posted a daily gain or loss of more than +/-1% 49 times so far this year.⁵ That averages at least nine moves a month — more than twice that of last year and the historical monthly average of four.

In another deviation from historical norms, 57% of these outsized moves were negative when typically there are more upside 1% moves in a year. And notably, the current 57% is greater than what we saw in 2020 at the start of the pandemic (41%), in 2018 when the S&P 500 Index last posted a yearly loss (50%), and during the Great Financial Crisis (56%). It also exceeds the historic yearly average of 47%.⁶

Moreover, the last time there was a higher percentage of downside 1% moves was 20 years ago in 2002 — a year when the market, reeling from the pop of the dot-com bubble and increased geopolitical risk from the 9/11 attacks, fell by 23%.⁷ While this does not forecast a dot-com 2.0, the performance of certain segments is similar, underscoring how the market is now trading more on fundamentals than narratives.

Target Quality as Narratives Change

The handover from the narrative market where “stock stories” featuring grandiose proclamations of revolutionary growth took precedent over actual sales coincides with a reduction in liquidity⁸ and higher hurdle rates (e.g., increasing real rates). This is most apparent within unprofitable high tech.

Non-profitable high-tech growth stocks are down 40% on average this year.⁹ Meanwhile, profitable high tech is down 17%, in line with the return of the S&P 500 Index. The same trend emerges when analyzing the market, beyond high tech.

Overall, non-positive earnings-per-share firms are down 35% in 2022. Meanwhile, positive earnings firms are down just 14% —better than the overall market. In fact, positive earnings firms have now outperformed negative earnings firms every month since June 2021, as shown in the following chart. This trend is a strong sign of increasing fundamental volatility, as high cash flow firms are more in favor than high cash burn-rate firms.

This emphasis on the quality of growth, and not just profitability, is reinforced by a concentrated basket of quantitatively screened high quality firms outpacing low quality by nearly 5% this year.¹⁰ Similar to the prior analysis on profitability, concentrated long quality has outperformed concentrated short quality in nine out of the past 12 months.¹¹

Performance, of course, is a byproduct of the fundamental backdrop. And the trends in analyst upgrades-to-downgrades provide another example of the market entering a more uneven fundamental environment. As shown in the following chart, the number of analysts upgrading 2022 earnings-per-share (EPS) estimates is essentially equivalent to the number of downgrades for US firms. And this ratio has been declining monotonically over the past five months. The US, however, is a beacon of strength compared to the rest of the world, as its ratio is the only major region above 1 — where it has been for some time.

Lower than expected growth in those regions — +6% for developed ex-US stocks and +1.5% for emerging markets (EM) — compared to US firms’ +10% earnings-per-share growth¹² make the US our favored market, followed by developed ex-US.

The case for EM is quite challenged right now, outside of it representing a value play. But sometimes things are cheap for a reason, and sluggish growth and weak sentiment, combined with heightened geopolitical risk, make EM a difficult overweight at the moment.

For those tempted to catch this falling knife, keep in mind that EM has been in bear market (a 20% decline) on 22% of the days over the past 10 years¹³ — leaving those who tempted fate empty-handed. And over the past decade, EM has underperformed developed markets in 85% of the rolling five-year periods.¹⁴

Analysts are not the only ones downgrading expectations. Firm guidance has been weaker as well. Following the most recent quarter results, more than 70% of S&P 500 firms have issued negative guidance.¹⁵ This is above the 60% historic average.¹⁶ As a result, earnings expectations for the second quarter have declined from 5.9% to 4.6%.¹⁷ Earnings surprises have also been lackluster, as firms have beat Q1 estimates by just 4.9%.¹⁸ This is below the historical 5-and-10-year averages of 8.9% and 6.5%, respectively.¹⁹

Revenue trends are better, with surprise rates above long-term averages. The same is true for growth.²⁰ Yet, as a result of margin compression, earnings are being hit harder. Net margins have declined for three subsequent quarters and in the most recent quarter, 50% of firms in the S&P 500 had margins decline from one year ago.²¹ This margin weakness stems from higher input costs, reinforced by the fact that 85% of firms reporting in Q1 mention inflation — the most ever.²² This risk was most crystalized by severely weak earnings reports from consumer goods and large retail firms in late May.²³

With weaker sentiment, firms that are unable to beat lowered estimates have been punished more than usual — falling 5.1% the day after releasing results compared to a five-year average one-day decline of 2.3%.²⁴ This trend further reinforces the rise of more fundamental-led volatility and the need to mitigate this non-macro related risk moving markets.

Place Value Alongside Quality in the Core

With waning sentiment, having a bias toward firms with more fundamental durability may be additive. However, while valuations for quality stocks have re-rated amid the recent broader market turmoil, the premium for quality balance sheets still exists.

Based on a six-factor composite valuation metric, pure quality strategies have a current valuation that sits in their own historical 67th percentile.²⁵ The premium for quality based on this composite metric is also five percentage points above its historical average. However, on a relative basis to the market, the average percentile rank of quality’s premium to the market is right at the median of 50%.²⁶ As a result, across each of the metrics, the average relative premium to the market currently is actually four percentage points lower than the historical average premium for quality (23% versus 27%).²⁷

With these results, it is clear that valuations for quality are neither supremely rich or cheap. Value, however, still screens as attractive — even after outperforming the market by more than 7% and growth stocks by 23% so far this year.²⁸

If we use the same six-factor composite valuation metric, value stocks trade in the historical 18th percentile relative to their own history and 9% lower than their average rate.²⁹ On a relative basis, value is equally as attractive. It sits in the 37th percentile with a discount to the market of -31%, greater than the historical average discount of -21%.³⁰ In fact, four out of the six metrics are all trading at a discount relative to their own history. And on a relative basis, as shown in the following chart, every metric is in the bottom quartile.

The case for value can be expanded beyond the current relative fundamental ratios. There is also a macro case to be made. Over the past 30 years, growth stocks’ monthly excess returns to the broader market have had a negative correlation to changes in interest rates (-17%), whereas value excess returns have been positively correlated (+18%).³¹

With the prospect for higher rates resulting from tighter monetary policy, longer-duration growth exposures (cash payments further out in maturity like a long-duration bonds) could be further challenged on a total return basis.

Given these dynamics, blending these two exposures together could be additive from an earnings durability perspective (the quality side) while also tempering overall valuations (the value component). And as of right now, for a US blend, the combined current relative valuation level is a -4% discount to the market, a nine percentage point improvement compared to the historical average relative valuation premium of +5%.³²