Is the Market Ignoring Balance Sheets to Chase the AI Boom?

Quality fell out of favor with investors in the wild rip of the AI boom in the last several years. Benjamin Lavine, Chief Investment Strategist and Model Manager, Freedom Investment Management, talks about this divergence with ETF.com's Dave Nadig at the Astoria Macro Summit in late October. Lavine weighs in on if investors should consider a return to quality in today's market environment, and what factors are worth diversifying into. 

Transcript

Nadig: People are nervous, normally that would imply that they would move towards higher quality names, but you don't think that's going on.

Lavine: So, we've never seen high quality this oversold in a momentum market, at least a trailing five-year range, and that just kind of reflects the market sentiment right now. It's not nervous, it's risk-on.

Quality Slides Out of Favor With Investors

Nadig: So, Ben, you and I were talking a little bit earlier about how things have changed over the last year, and it’s certainly been a lot. And you have a little bit of a thesis that we've kind of denigrated one of our core factors, quality. Talk to me what you mean about that. How do you think about quality and why do you think it's so out of favor?

Lavine: Sure. So, just to define quality, it is the factor that is based on what you consider to be high quality – whether it's profitability, low financial leverage, low volatility. Those themes have been out of favor since Liberation Day.

Nadig: That just sounds like good company to me.

Lavine: Yeah. Well, basically, whether you – if you look at the opposite, high beta momentum for instance, unprofitable tech, meme stocks, they have been running hard versus the broader averages. The opposite of that being high quality, which is low volatility, low financial leverage. Basically safe balance sheets that have profit margin that have high return on invested capita. They've been underperforming since Liberation Day.

Nadig: So, help me understand why that might be the case, because it's not that there aren't plenty of people playing defense out there. I hear from advisors – we're here at the Astoria Macro event – plenty of people are talking about playing defense, buying gold, buying bitcoin, you know, international bond diversification, you name it. People are nervous. Normally that would imply that they would move towards higher quality names, but you don't think that's going on.

Lavine: No, if anything, they're not nervous, as reflected in gold miners, reflected in even things like utilities. There at the conference today, several pointed out the stat that the AI themes, if you tie them together, which includes utilities, now make up 50% of the S&P. Well, utilities, if you look at them, they generally are considered lower quality because of their balance sheets. So, if you were to break down the High Dividend Index, for instance, and you'd see what's really driving the performance within that index, it's utilities. It's not the traditional safe havens like staples and healthcare and others that you typically see that make up that basket.

So, when you tie it all together, whether you look at high quality as a theme, as a risk factor, when you measure it against – when you put it through the factor lens – valuation, momentum, and so forth, you see that on a momentum basis at least, traditional momentum metric, it's at a five-year low. So, we've never seen high quality, well, not never, we've not seen high quality this oversold in a momentum market over at least a trailing five-year range. And that just kind of reflects the market sentiment right now. It's not nervous, it's risk-on, and you see that most prominently in the dispersion between high quality versus low quality names.

What Turns the Tide for Quality?

Nadig: So, what inverts that? Because I mean, we also have to point out like the best performing asset this year is gold, right? So, like that's a little bit counter. People would often think of those being in similar buckets. What's going to have to happen for folks to come back to high quality stocks? Is it that we need like the AI bubble to go "poof?"

Lavine: Well, we saw a bit of that actually pre-Liberation Day, when the initial tariffs were announced on steel, on autos, on aluminum, and that got the market nervous a little bit. High quality, high dividend actually performed well.

Nadig: Had a moment, right.

Lavine: Had a moment. And then it all reversed, right? Right after Liberation Day, when it looked like the worst of the tariff policies weren't necessarily either they were not going to be implemented or the impact wasn't as great as what people were fearing at the time. So, a shift in sentiment on quality really requires a shift in sentiment on the broader economic outlook, on the broader themes.

You need to start seeing certain themes falter from the weight of the prices that have been driven up. You've kind of seen it in the tertiary plays like quantum computing, some of the peripheral AI names. But, for the most part, as long as the CapEx is flowing into the theme, investor appetites are wedded such that they really don't care about whether there's a balance sheet, whether there's profit margins, whether there's even revenue. Because they are investing for tomorrow. And until tomorrow looks less rosy and can't support the capital flows that are funding that, you're still going to see sort of this meme-driven risk-on type of sentiment.

Nadig: So, what's a normal investor to do here? Because, you know, in general, I tend to – my own money, long-term buy and hold. I'm not moving stuff around on this at all. But, you know, this has been a fairly consistent trend this year we've seen. Is this playable for somebody who's not monitoring this day-to-day?

Is this the kind of thing that you would actually recommend people reposition around and try to get ahead and maybe overweight quality in their portfolio or underweight some of the momentum? Or do you think this is too unpredictable and it could go this way for five more years and it would be a mug's game?

Lavine: Well, I mean, you know our firm. We've favored the Fama-French-based approach in terms of our model build-outs. Fama-French factors – value, size, even now profitability – have been out of favor. We still recommend maintaining a value tilt and a size tilt. And even outside of the large-cap, megacap outperformance, we are starting to see signs of small-cap and mid-cap outperformance. It's been hit or miss, but for the most part, since the worst of the Liberation Day sell-off, we've actually started to see small- and mid-caps come back relative to large-caps.

International also has been holding up. More recently emerging markets, but earlier in the year, Japan and Europe. And so, we just think that diversification – you can still have full risk-on exposure in equities relative to cash or fixed income. But you should be diversified across the globe, across different themes, across different factors, but it feels increasingly that investors would rather be concentrated in the one area of the market that continues to work. Which is, you can call it AI, but increasingly it's the high beta momentum type of trade.

Nadig: Ben, this has been great. Thanks so much for giving us some stuff to think about. Cheers.

Lavine: Sure, nice seeing you.