Are We Witnessing a Return to Quality?

While value is the talk of the town, as the economic cycle evolves, quality stocks are likely to come back into focus.

Looking at the Invesco S&P 500 Quality ETF (NYSEArca: SPHQ) and its 16% year-to-date gain, it’s clear quality is already on its way. In a note to clients, Bank of America analysts noted that they have a “favorable” rating on domestic quality exchange traded funds, while adding that SPHQ has been upgraded to “buy” from “neutral.”

“We upgrade SPHQ to Buy because of its strong fundamental profile, with the highest share of quality stocks relative to Underperform-rated stocks and underweighted sectors,” said Bank of America.

The $2.94 billion SPHQ allocates barely more than 3% of its weight to energy, materials, and real estate stocks – sectors that, owing to some sizable debt burdens among member firms, can sport lower quality metrics. Conversely, SPHQ allocates 37% to technology – a group known for high return on equity and return on assets.

SPHQ 1 Year Performance

SPHQ Has Plenty of Tailwinds

A variety of factors could propel quality stocks and ETFs like SPHQ in the back half of the year. Those include valuations. As Bank of America notes, quality – a factor that usually commands premium valuations – boasts 10-year low price-to-earnings multiples.

The bank added that “quality outperforms when the Fed tapers asset purchases” and that when earnings growth slows, investors often pay up for quality stocks.

“We expect the valuation gap to close and the macro, policy, and profits triggers to benefit high-quality stocks over the next several quarters. Flows to quality ETFs already appear to be turning higher,” said the analysts.

Speaking of inflows, investors have added $172.49 million to SPHQ year-to-date. While that may not sound like much, more than $124 million of that sum arrived in June alone. Investors that aren’t yet exposed to quality may want to consider making the move sooner rather than later for multiple reasons.

First, the value rally has been led by junkier stocks, but some market observers believe a rotation to higher quality value names is already underway. Second, some of the macro conditions that are supportive of quality may already be here.

“We expect each of these conditions to occur over the next 6-12 months. The early-cycle valuation gap is likely to close, the Fed may begin tapering asset purchases; corporate profits will likely peak, and peaking PMIs and higher volatility will push investors toward higher-quality stocks,” concludes the Bank of America analysts.

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The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.