Talk about a crazy market – high volatility and high quality stocks have both rallied this year. It is not normal, but there is an explanation.
Typically, when investors buy high-volatility stocks to send them higher, they sell quality names. The idea is to turn the economy away from higher returns, which many high-volatility stocks benefit from the most.
Conversely, investors will buy higher-quality names, sometimes selling economically sensitive, more volatile names, to protect their portfolios from tough economic times. Quality names usually have some combination of earnings consistency and lots of cash on their balance sheets.
This trade-off is not exactly how the market has moved this year. It
Invesco S&P
500 High Beta ETF (ticker: SPHB) that selects the 100 most volatile stocks
S&P 500,
this year it has increased by about 20%. And still
Invesco S&P 500 Quality ETF
( SPHQ ), which selects companies with various characteristics such as high return on equity, a performance measure that shows earnings as a percentage of net assets, is up just 13% this year. At first glance, it seems strange that the two funds are working together.
To understand why this happens, start with the high volatility part of the equation. Economically sensitive names rose as markets are convinced that demand for goods and services will improve soon. The idea is that the Federal Reserve is nearing the end of its rate hike campaign, which means cool inflation, dampening demand.
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Among economically sensitive stocks, Generac ( GNRC ) , which sells power generators to homeowners and businesses, is up more than 50% this year. Royal Caribbean Group ( RCL ) has more than doubled, and Norwegian Cruise Line ( NCLH ) is up nearly 75%. Caesars Entertainment ( CZR ) is up more than 15%.
The fund is fairly balanced, so other stocks are contributing to gains, including Big Tech. Nvidia (NVDA), the fund’s largest holding at even 2%, nearly tripled. Its volatility comes in part from price/earnings multiple movements that reflect changes in the long-term outlook for earnings growth and the premium investors are willing to pay for those future earnings.
That premium rises when the market sees exchange rates holding steady or falling. The stock has soared as artificial intelligence expands the chip market. Meta Platforms (META) has more than doubled this year.
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So why does quality performance depend on high volatility? The simple answer is that Big Tech is also in the bucket of quality, and it remains a high-growth group enjoying a steady pace.
“When you ease the recession and you ease the inflation, that’s why you can have beta and quality work at the same time,” said Victor Kosel, macro strategist at Seaport Global Securities.
Apple ( AAPL ), Microsoft ( MSFT ), and Alphabet ( GOOGL ) are up between 33% and 51% this year. The latter two are benefiting from larger markets thanks to their AI advances, while beloved Apple has been caught up in a broader tech rally. Chipmaker Broadcom ( AVGO ) surged more than 50%.
These stocks plus Nvidia and Meta make up almost 30% of the quality pool because they have such high quality scores. If the fund had been equally weighted, removing the size effect of these stocks, it would have gained less than 9% for the year, according to Dow Jones Market Data, less than half the gain of high-volatility names.
The technology is high quality because, while it has its drivers of volatility, it has dampening factors. Apple has so much cash that it seems like no one can compete with it for long.
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Microsoft
of
The return on equity in 2022 was about 44%, compared with 21% for the S&P 500, according to FactSet.
Sometimes high volatility stocks and high quality actually work together. Don’t be fooled by traditional market theory.
Email Jacob Sonenshine at jacob.sonenshine@barrons.com
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