Some strategists are noting that the bounce in January was driven by lower quality names and sectors. Others are pointing out that the earnings picture continues to soften.

Merrill’s Equity Strategy group notes that Higher quality is still cheaper than lower quality, and that within large-cap stocks, high quality has traded at a significant P/E discount vs. low quality ever since the tech bubble.

The key, in their view, is the deleveraging cycle. They hypothesize that this anomaly with see valuations to converge. My view of the secular bear psychology is that frustrated investors become willing to spend less and less on a dollar of earnings, compressing ALL multiples.

In my perspective, the phenomena seems more psychology driven. Sure, issues like quality, deleveraging, cap size (as well a Euro troubles) are relevant, but they drive investors risk appetites.

The factors above becomes more significant if and when earnings growth slows even more appreciably than the present quarter. In that environment, higher quality, larger firms become more (not less) favored. We have seen that begin recently.The chart below showing the ratio of Russell 2000 small caps versus S&P500 large caps epitomizes this.

Look at the chart below. The periods where small caps are outperforming their larger brethren are depicted as blue lines.  larger cap out performance are the yellow lines. The big caps seem to do better when the rally loses steam (Sept-Dec 09); when the market softened before QE2; and again before Operation Twist.

In other words, the Risk On, Fed-liquidity driven trading. Left to its own devices, the market seems to be softening as the economy stumbles along.

The Fed’s emphasis on making “cash = trash” is what is driving small caps and lower quality names.


Russell 2000 Small Caps versus S&P500 Large Caps


Merrill’s strategist notes that “As corporate profit growth decelerates, quality tends to win out” and on a relative basis, I agree. On absolute basis, quality may simply fall less than momentum names. Not exactly a place to hide from the storm — just a place to get less beat up . . .

Category: Earnings, Investing, Psychology

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4 Responses to “When Earnings Slow, Focus on Big Cap, Quality”

  1. [...] If earnings slow, focus on big cap, quality names.  (Big Picture) [...]

  2. CANDollar says:

    Couldn’t multiples begin to trend lower rather than higher as seems to be consensus:

    Usually with low interest rates the p/es would be higher but rates are low for a reason and also are being kept low artificially with great externalities such as penalizing savers and retirees.

    Higher taxes on the horizon imply lower p/es.
    People are moving out in duration in order to get yield. Stocks are longer duration because they discount relatively far into the future but the low growth prospects of the economy imply higher discount rates and therefore lower p/es.

    The real interest rate is very low and this is often a leading indicator of p/es for the market… implying p/es have potential to drop even more.

    p/es could go down to 11.6 because this is the average level that it goes to over the past 140 years when interest rates are negative (I think I read that here).

    All this adds up to tremendous vulnerability to shocks and a lower growth trajectory.

  3. Boots or Hearts says:

    Nice post, thanks for sharing the perspective.

    I think the notion that we are seeing almost complete mini business cycles between QE’s is interesting. If that continues for several years, and who can say but the governnents and central banks have obviously chosen this path- what does that imply for investing over the next 5-10 yrs?

    Certainly not blind buy and hold

  4. pintelho says:

    quality in and of itself is a subjective concept…

    is there an analysis about when things are good…do the quality names outperform their losses during the times when things are bad?

    losses happen, downtrends happen…what good is it to go pick up some “quality” if these names don’t come back far enough to recover their losses during the next downtrend when “low-quality” gets the rally cap.