Russ discusses why low vol and quality stocks are exhibiting surprisingly strong performance.
Since the start of earnings season two trends have been noticeable: Stocks have been range-bound and volatility has risen, up around 40% from the early April low. In other words, despite a stellar earnings season, in which more than 85% of companies beat estimates, stocks have mostly churned.
That said, not all equities have struggled. Cyclicals surged in May, led by energy, materials and financials (see Chart 1). Conversely, market segments that thrived last year have struggled. On a one-month basis technology and consumer discretionary shares are down roughly 5%.
Global sector performance – 1 month return as of May 2021
To some extent none of the above should be a surprise. Cyclical sectors have been leading since the fall, while tech has been a funding source, as investors reposition for the fastest growth in decades. What is less obvious is the resilience in less cyclical, lower risk parts of the market. Since the beginning of earnings season low volatility and quality strategies have narrowly outperformed the market. It is somewhat odd that in an environment custom made for value and cyclical names, stocks often owned for “safety” are holding their own.
The fact that low volatility and quality are both doing well is partly explained by the overlap between the two styles. Price volatility, which defines the minimum volatility style, is influenced by fundamental volatility. Profitable companies with steady earnings generally experience lower price volatility than companies with highly cyclical earnings. These similarities are also evident in the correlation between the styles. Since last fall min. vol has had a 90% correlation with quality, versus less than 70% for value.
Investors often associate these styles, particularly min vol, with more defensive sectors, notably staples and utilities. While it is true that by nature these sectors tend to have stable earnings and lower price volatility, neither investment style is limited to defensive sectors.
For example, as my colleague Isabelle Liu recently discovered, the current bias towards quality is proving effective in most cyclical industries. In fact, the efficacy of quality themes, particularly profitability and earnings consistency, has been even more prominent within cyclical sectors. Looking at gross profitability, we see strong performance in cyclical industries, including transport, retail and consumer durables. Similarly, investors are also demonstrating a preference for earnings consistency in cyclical industries ranging from tech hardware to banks.
While I would continue to emphasize cyclical names, there is a place in a portfolio for complimentary styles. Previously, I discussed the challenge of finding reliable hedges in the current regime. The standby hedge of the past several decades, U.S. duration, now plays a diminished role. With no single asset class able to fill the gap, investors need to cast a wider net to insulate a portfolio. Quality and low volatility are performing their function: providing upside while helping to manage overall portfolio volatility.