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By Joe Hudepohl, CFAPortfolio Manager and Managing Director, Atlanta Capital

Atlanta - As U.S. equity markets move away from a pattern of extreme concentration by a handful of stocks, we believe we are seeing the beginning of a "sweet spot" for high-quality investing,1 with investors increasingly favoring companies with solid fundamentals and long records of consistent growth.

Over the past several years, we've pointed to the huge concentration of a few holdings dominating U.S. equity index returns — whether it's the S&P 500 or the Russell 1000 Growth (Exhibit 1). This pattern appears to have flattened out recently. Although some technology stocks continue to do well, we have seen some of the most expensive momentum names give up ground. We think this is an encouraging sign that the market may be shifting away from just a few exclusive leaders.

Exhibit 1: Extreme Concentration in Russell 1000® Growth Index in Recent Years


Buffett Indicator at All-Time High

Along with market concentration, we've also seen equity markets get very expensive over the last year. Looking across a range of valuation metrics — whether price-to-earnings (P/E) ratio, price-to-book or price-to-free-cash-flow — we've generally seen these fall within ranges near all-time highs. Even more telling of the market's richness, we think, is the S&P 500 market-capitalization-to-GDP ratio, the so-called Buffett Indicator. This ratio is used to determine whether an overall market is undervalued or overvalued compared to a historical average. It reached a new peak in 2020, surpassing what we saw in 2000 from a market-cap perspective (Exhibit 2).

Exhibit 2: U.S. Stock Market Most Expensive in Decades


Low Quality a Culprit

Digging deeper, in our view, the market's low-quality tilt in recent years has been a key driver of high valuations and market expensiveness. In 2020, we saw the divergence between low-quality versus high-quality stock performance peak, spurred in part by market speculation. We've only seen low quality valued this highly on a P/E basis in two other time periods, one being in 2008-2009, the other in 1999 to 2000. As we know, both periods ended in a correction that was challenging for equity investors overall, but less so for a high-quality approach. Although past market actions can't be seen as predictive of the future, we believe we are now in a similar time period, where low quality is extremely highly valued. In our view, this environment may be signaling a shift to high quality.

In fact, we have started to see a modest uptick in high quality over the last three months, notably during a period of volatility as concerns grow around inflation, supply chain shortages, COVID-19 variants and the economy overall. The direction of interest rates is another major focus of the markets. As rates move up, that typically brings market volatility, and historically, rising rate environments have favored higher-quality securities. If you look back over the last couple of periods of rising rates, typically, as rates begin to rise, a few quarters later, quality tends to do well.

In terms of portfolio strategy, we continue to pursue a high active share, meaning our holdings are typically quite differentiated from a benchmark index, and are staying the course with most of the businesses we own. We think we are starting to see a market transition. We've seen this especially over the last three months with an uptick in high quality and a lessening of the headwinds faced in 2020. Looking ahead, we think high quality is a space offering abundant opportunity for the foreseeable future.

Bottom line: A range of market factors point to a potentially improved environment for high-quality investors. In view of high market valuations, economic uncertainty and volatility, investors may seek higher-quality, sound businesses with demonstrable, consistent earnings and balance sheets versus their lower-quality counterparts.

1 Higher-quality companies typically have consistent earnings, strong balance sheets, significant free-cash-flow generation, growing revenues and meaningful competitive advantages, whereas the opposite is true for their lower-quality counterparts. Historically, high-quality equities have outperformed over full market cycles.

S&P 500® Index is an unmanaged index of large-cap stocks commonly used as a measure of U.S. stock market performance.

Russell 1000® Growth Index is an unmanaged index of U.S. large-cap growth stocks.