A Flight to Quality?

The investment environment changed dramatically in mid-May as investors seemed to switch their focus from growth-oriented stocks to value. I shared my theory the other day that it seemed like more of a case of buying anything that hadn’t rebounded from its March low. We saw insane gains from various oil companies, banks, industrial companies, etc. I specifically mentioned airline stocks as the likes of American Airlines and United Airlines soared over 100% in just a few short weeks.

A theme I have heard often in investment news is “flight to quality”. I can’t say that I have heard anyone ever say there was a flight away from quality, but that almost seems like what was going on in the last few weeks—that is until these last few days where we have seen some serious selling. Those same stocks and industries that jumped so sharply in recent weeks have been the ones that have been hit the hardest this week. The stocks that soared without much reason are falling almost as fast. American Airlines is down 36% from its high and United is off 32.5%.

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Watching lower quality stocks soar while higher quality stocks floundered was especially frustrating for me because the stocks I buy and the ones I recommend to subscribers are all high quality stocks that have strong earnings and revenue growth as well as strong management efficiency measurements like return on equity and profit margin. Since mid-May, it seemed like we were seeing panic buying of low-quality stocks and selling of high quality stocks. I can’t think of any scenario where that makes sense.

I have some evidence to back my theory as well, it isn’t just based on my gut instincts.

In addition to writing for Bull Market Rodeo, I write for a company called Tickeron. Tickeron is an artificial intelligence-based investment platform. The goal is to use quantifiable indicators to measure the likelihood of success of a trade. The company uses proprietary fundamental indicators along with traditional technical indicators to measure the quality of a stock.

Just a few days ago I was writing a story about internet retailers and how the global economic shut down was impacted these companies. I used five well-known names that see significant trading volume and are mid-cap to large-cap stocks. The five included Alibaba, Amazon, Overstock.com, Shopify, and Wayfair.

I sorted the stocks based on their returns over the last three months and then looked at the fundamental ratings. The three stocks that had performed the best over the last three months were the three with the most negative marks while the two with the fewest negative marks were at the bottom of the list. Overstock.com had led the way followed by Wayfair and then Shopify.

The two at the bottom based on percentage return over the three month period were Amazon and Alibaba. I have Alibaba in my portfolio currently and believe it is a high quality company.

I kept the same order and then did a screen for the technical indicators. Amazon and Alibaba didn’t have a single negative mark at that time while Overstock, Wayfair, and Shopify all had either two red marks or four red marks.

This is honestly one of the most bizarre things I have seen. And it wasn’t just internet retailers where I saw this phenomenon happening. It seemed to be the case with airlines, industrial companies, and banks.

This week we have seen the market drop sharply with the selling accelerating after the Fed meeting and announcement. The stocks that shot up so fast are falling faster than the laggards—a reversion to the mean if you would. Hopefully, this is a sign that things are returning to normal as I don’t know how to justify buying low-quality stocks.

I’m writing this on Thursday afternoon and I went back and looked at the last 15 option recommendations to see what the stocks are doing with the market in full meltdown mode. In the last 15 recommendations, there have been 11 bearish trade ideas and only four bullish trade ideas. All of the bullish ideas have been on stocks with strong fundamentals and the bearish ones all have weaker fundamentals—that’s one of the determining factors. The average return for the bearish ideas at 2:00 PM on Thursday was -7.65%. The average return for the four bullish ideas was 0.46%.

As frustrating as it is when the market isn’t working the way you want it to, I truly believe that buying quality stocks will win out in the end.

About Rick Pendergraft

Rick has been studying, trading, analyzing and writing about the investment markets for over 30 years. He has worked for some of the largest financial publishers in the world and he has been quoted in the Wall Street Journal, USA Today, the New York Times and the Washington Post. In addition, he has been interviewed on Bloomberg, CNBC and Fox Business News. Rick’s analysis process includes fundamental, sentiment and technical analysis. Rick started college as an education major, wanting to teach economics, but eventually changed to majoring in Economics and received a Bachelor of Science in Economics from Wright State University. His desire to inform and educate people is at the heart of his writing.

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