Markets have calmed down in recent days. Still, while U.S. stocks have managed to recoup roughly half of their recent losses, there has been a palpable shift in the environment. Markets no longer end each day at all-time highs and the S&P 500 Index’s annualized return no longer approaches triple digits.
Another manifestation of this regime shift is volatility. The VIX Index has retreated from its unprecedented spike, but at nearly 20 it is still double the January low. In other words, investors expect twice as much near-term volatility as they did one month ago. Assuming this continues—i.e. we experience episodic spikes in volatility—investors may want to consider adding more quality stocks to their equity portfolio. This of course leaves the question: What exactly constitutes “quality” in a stock?
What is quality?
As I discussed back in October, while there is no single definition, quality typically connotes some combination of high profitability, low debt-to-equity and earnings consistency. In aggregate, this style offers two potential advantages. First, quality has historically delivered a return premium, i.e. the opportunity to outperform a broad benchmark over the long term. Since 1990, the MSCI Quality Index has beaten the S&P 500 by approximately 0.10% per month on average (see accompanying chart).
In addition, quality tends to perform best when other styles, and the broader market, are struggling. Quality typically outperforms momentum during periods of turbulence. During the most recent pullback, quality once again outperformed, albeit by a relatively small margin. Most likely, part of the reason quality did not offer more protection was the nature of the selling. Rather than a shift in the economy, investors were dealing with a technical unwind of a particular trade: short-volatility. As such, the selling was indiscriminate rather than reflecting a change in market fundamentals.
That said, over the long term quality has proved its worth, particularly during periods characterized by rising volatility. Since 1990, in months when the VIX rose by 20% or more, quality beat the S&P 500 by an average of approximately 60 basis points (bps, or .60%). Nor is the average a function of a few, very good months. When volatility was rising sharply, quality beat the broader market 75% of the time.
The downside is that under more benign market conditions, quality generally trails more aggressive investment styles. As discussed back in October, quality tends to underperform momentum when markets are calm. The takeaway: For investors expecting a resumption of the January rally, a tilt towards momentum—as my colleague Kate Moore suggests—or value may be more effective at milking the rally. For those expecting less calm seas, a tilt towards quality may help diversify risk-seeking tilts to momentum or value.