Exuberant stock investors are embracing risk again as they scoop up equities with weak earnings quality, just a few months after stocks fell within a hair of a bear market. This group of riskier stocks, surprisingly, has posted average gains of 18% through the first two months of 2019, dramatically higher than the average 13% gain of higher-quality stocks with more stable earnings, according to a recent study of 1,200 stocks by Bank of America. Some of the top performers come from the communications, energy and utilities sectors, according to a detailed story in the Wall Street Journal.
Riskier Stocks Beating S&P 500
(performance in first 2 months of 2019)
- Riskier Stocks + 18%
- Higher Quality Stocks + 13%
Source: Bank of America, per WSJ
What it Means for Investors
The return to riskier stocks has partly been driven by the Federal Reserve’s more dovish stance as it holds off on further rate increases for the time being. Growing optimism about trade negotiations between the U.S. and China is also playing a role.
Bank of America defines these risker stocks as ones with weaker earnings quality and stability. The risk is that low-quality stocks tend to be sold off first when markets turn bearish as investors seek safer investments. That happened during the fourth-quarter sell-off and also when stocks pulled back last week. The riskiness of low-quality stocks lies not only in unreliable earnings or even losses, but they often have higher debt burdens, according to the Journal. These weaknesses emerge when the economy deteriorates or slips into a recession. "With the market starting to give back some of the gains, higher-quality companies are going to come back in vogue,” Sam Stovall, chief investment strategist at CFRA Research, told the Journal. He added, "They’re not the swiftest of boats, but they’re the most buoyant.”"
Many low-quality stocks include high-growth internet stocks, media companies and telecom companies in the communications sector, says Bank of America analyst Jill Carey Hall. Internet companies Facebook Inc. (FB) and Netflix Inc. (NFLX), video game company Electronic Arts Inc. (EA), and television services provider Dish Network Corp. (DISH) have blown ahead of the market this year with year-to-date gains of 32%, 33%, 24% and 30%, respectively.
While riskier stocks have rallied from the late 2018 selloff, the exuberance is unlikely to last as a number of macro risks still loom over the U.S. and global economy. “We’re seeing and expecting higher volatility around these macro events and quality stocks are where you would want to position yourself,” said Bank of America's Carey Hall.