Peak Everything Puts Shine on Equity Market’s Sturdiest Stocks

As Wall Street debates the timing for Federal Reserve stimulus cuts, investors have already shifted gears, targeting well-heeled companies that can weather a slower-growing economy.

S&P 500 firms with strong balance sheets have outperformed those with shakier finances for three straight months, the longest stretch since May 2020, according to data compiled by Goldman Sachs Group Inc. and Bloomberg. That’s a reversal from the start of 2021, when shares in companies with tattered finances thrived as the economy reopened, beating quality firms by the most on record. 

The shift in investor preference tracks with a slowdown in economic growth amid the resurgent virus. Hiring data Friday badly missed estimates, the latest in a string of weak numbers landing just as enhanced U.S. unemployment benefits are set to expire and the Fed considers pulling back pandemic-era support. Such a recipe for slower growth could leave some poorly capitalized firms vulnerable, increasing demand for companies with the strongest finances.

“What we’ve been positioned for is the end of peak growth, peak stimulus, peak accommodative policy,” Emily Roland, John Hancock Investment Management’s co-chief investment strategist, said by phone. “It’s companies that can ward off margin pressures as input costs go up — and that all leads us to companies with great balance sheets and strong fundamentals and that’s really where we’ve been overweight.”

The group that’s been on fire lately is the 50 firms that score best when measured against five financial ratios calculated by Goldman Sachs Group Inc. Among them, Adobe Inc. has jumped 14% in the third quarter, while Costco Wholesale Corp. added 17% and Alphabet Inc. rallied 18%.

The rotation was on display in the five days ahead of the holiday weekend, as investors piled into the tech-heavy Nasdaq 100 Index, pushing it to a 1.4% gain. The S&P 500 lagged behind, rising 0.6%. It notched an all-time high Thursday before slipping after the weak jobs data.

The summer romance with high-quality companies has helped the group catch up to the reopening darlings, such as financials and real estate, that remain the year’s best performers. Over the past three months, tech companies sitting on piles of cash and generating billions in profits have moved back to the top of the leader board.

Of course, not everyone’s ready to give up on the cyclical trade just yet. ETF investors have poured over $1 billion this week into companies that would benefit from a continued surge in economic activity, suggesting they are betting the recovery won’t flag into year-end.

At the same time, investors have clearly grown nervous about the impact from the delta variant and the Fed’s tapering plans with stocks near all-time highs. Traders bid up protection against a market downturn and shifted cash into quality names. 

Another gauge of financial strength comes from a Bloomberg measure of a company’s risk of default within one year. That shows that the quartile of Russell 1000 stocks least likely to go under has gained non-stop since June, outperforming for three straight months the group most likely to falter. That’s the longest such streak since March 2020.

“Longer-term, good balance sheets tend to outperform bad balance sheets. Investors, right now, because we’re at all-time highs, are nervous about a selloff, so what they’re saying is, ‘OK, if we do have a selloff, where do I want to be longer-term?’” JJ Kinahan, chief market strategist at TD Ameritrade, said in an interview. “So they may go down too, they may not go down as much. And they have a better opportunity to come back in a quicker fashion.”

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