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Many of these industries are underpinned by impressive profits: nine of the eleven S&P 500 sectors posted year-over-year earnings growth, with five boasting double-digit growth.
A curious dynamic has asserted itself in the markets this year: the low-quality rally. While the S&P 500 is enjoying its third consecutive year of double-digit returns, speculative pockets of the market have climbed multiples higher than the index’s performance. Yet, the air in this balloon is sputtering out, with a stunning reversal underway in low quality stocks.
To track the low-quality rally, our equity research analysts identified stocks within the Russell 1000 and Russell 2000, screening on metrics such as weak operating and free cash flow margins, high leverage, negative capex spending relative to sales, and elevated short interest. They unearthed 23 stocks in the Russell 1000 and 29 stocks within the Russell 2000, comprising what we’ve dubbed the large and small cap “Memes & Themes” indices. The two indices contain burgeoning AI companies, crypto miners, nuclear energy, quantum computing, aerospace, metals and rare earth minerals, EVs and specialized biotech – areas that have garnered significant enthusiasm without solid fundamentals.
After the spring market low, it was off to the races for our “Memes & Themes” indices. From April 8th through October 31st, large cap “Memes & Themes” was up 113% vs. 37% for the Russell 1000, while small cap “Memes & Themes” catapulted 256% compared to the Russell 2000’s 41% rally. Meanwhile, the quality factor advanced just 29%, suffering the worst October YTD underperformance relative to both the Russell 1000 and S&P 500 since its 1998 inception.
Yet, market anxieties around AI and valuations prompted a pullback, with large and small caps falling 4% and 6%, respectively, by the third week of November. As the tide rolled out, the poor fundamentals within “Memes & Themes” were laid bare. Large cap “Memes & Themes” fell 12%, while small cap “Memes & Themes” plunged 35% – for perspective, worse than the S&P 500’s COVID selloff. Both indices pared losses in the final week of the month, closing -3% and -18%, respectively, but the mid-month pullback forewarns investors that a steeper correction could have a deeper impact.
Meanwhile, quality fell just 2% intra-month and ended November with a positive absolute return, a tacit reminder that when everything rallies, nothing matters, but when sentiment sours, fundamentals are paramount. Quality has a history of preserving returns when the tide turns, enjoying its strongest outperformance over the S&P 500 in 1999, 2008, 2011 and 2023.
Given this dynamic, investors should consider leaning into quality across the market cap spectrum and seeking opportunities in many industries enjoying strong fundamentals, including pharma, capital goods, banks and utilities. Many of these industries are underpinned by impressive profits: nine of the eleven S&P 500 sectors posted year-over-year earnings growth, with five boasting double-digit growth.
Markets are recovering, but last month’s jitters demonstrated that low-quality rallies may burn bright, but also flame out.