Insights

Charting the Market: Prioritizing Profits in the Next Phase of the Rally

  • Profitability has mattered more lately than in prior phases of the market rally
  • Unprofitable firms have trailed profitable ones within broad US, growth, value, small caps, and sectors over the recent months
  • With this trend expected to continue into 2022 as sentiment wanes, investors may want to consider adding a quality overlay to portfolios
Head of SPDR Americas Research
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Profitability has mattered more lately than in prior phases of the market rally. This trend is also likely to continue into 2022, as the cycle matures, variants impede a full recovery, and policy decisions start to create more volatility – both macro and fundamental.

In this charting the market, I will showcase profitability trends and how a focus on quality stocks may help you to navigate the path ahead.

Profiting from No Profit?

As mentioned in our 2022 ETF Market Outlook, profitability was less of a concern during the first part of the pandemic rally. From May 2020 to May 2021, US stocks with negative earnings over the prior 12 months outperformed firms with positive earnings by 34%. Since May 2021, that performance trend has flipped. Unprofitable firms have trailed profitable ones by 7%.1

A more in-depth study reveals the same trends, but on a broader scale. The chart below shows the same analysis, but broken out by market cap, style, and region of focus. The trend was quite consistent throughout and shows that, at first, it didn’t matter if firms were profitable — until all of it sudden, it did.

Performance Difference between Non-Profitable and Profitable Stocks

Using a pure factor approach shows a similar trend. The chart below uses the Bloomberg US Pure Profitability Factor, a basket of stocks aimed at maximizing exposure to the profitability factor by going long stocks with high return-on-assets and return-on-equity levels, while shorting those that have poor figures for those metrics and optimizing to control for other factor or industry risks. As shown below, this highly concentrated quantitative exposure began to rally during the summer and has noticeably taken off since. Yet, it does remain below pre-pandemic levels, indicating the potential for more room to run.

Bloomberg US Pure Profitability Portfolio Total Return Index

The rationale for the turn in performance can be partly explained by three variables:

  • Rates began to rise, and given that some of these unprofitable firms have lofty growth expectations, a higher discount rate weighed on valuations
  • Liquidity-fueled exuberance waned after the initial bump, and fundamentals were once again in focus
  • The price reaction ran ahead of fundamentals, as earnings sentiment has soured over the past few months – in particular starting in June/July, as shown below

2022 EPS Revision: 3-Month Up-to-Downgrade Ratio

Intra-Sector Profitability Important

Despite the consistency of this performance in profitability, one could argue that there might be sector effects impacting these profitability trends. The data doesn’t support this notion. For starters, the Bloomberg Pure Profitability Factor seeks to neutralize sector effects and that exposure has rallied. However, if running the same analysis as earlier with styles and market caps but controlling for sector tilts by creating sector- only profitable and non-profitable portfolios indicates that, even within sectors themselves, a higher emphasis on profitability has been placed as of late than in earlier stages of the rally.

As shown below, only two sectors, Materials and Energy, have had non-profitable stocks beat profitable ones in the past few months within their respective sector. This differs from the earlier part of the rally when the magnitude of outperformance of non-profitable to profitable stocks was significant and consistent across all sectors.

Performance Difference between Non-Profitable and Profitable Stocks

Interestingly, one of the sectors (Energy) that has bucked the profit versus non-profit trend is also the one that scores the worst on a rank of profitably metrics overall, as defined by the process to create the Bloomberg Pure Profitability Factor (Return-on-assets, Return-on-equity, Return-on-capital, and EBITDA Margin). Within the S&P 500, Energy has zero firms in the top decile of highly profitable firms. This tells me that within that specific sector, there really isn’t a big difference between profitable and non-profitable firms. Therefore, the intra-sector analysis for that sector is not that meaningful.

On the flip side, within the S&P 500, Health Care and Tech have the most names within the top decile of these combined profitability rankings, at eight and 18, respectively. They also have most on a net-basis, after considering the number of firms from those sectors in the bottom decile of quality —a slight indication that those two sectors may be of higher quality than others.

Focus on Profits for the Path Ahead

The outlook for risk assets remains constructive given supportive, albeit slowing, growth and still easy monetary policies, even as tightening begins. Yet, with growth transitioning to a simmer from a boil, there has been a greater emphasis on firms with higher quality balance sheets and reliable profitability.

I’d expect this to continue into 2022, and investors may want to consider adding a quality overlay to portfolios —either by focusing on quality with factor exposures or by overweighting market sectors like Tech and Health Care.

For more market insight, check back to SPDR Blog and read our monthly chart pack.