Macroeconomic drivers are creating an unnatural market environment in which low-quality stocks are outperforming companies with stronger fundamentals, according to an analysis by Hennessee Group, a hedge-fund investment consultant.
Companies rated C by the S&P returned a whopping 65.7% over the past seven quarters, while A-rated stocks returned just half that, 33.6%. And it’s not because those C stocks are diamonds in the rough. “Lower-quality stocks should drop dramatically, but right now all ships are rising because of quantitative easing by the Fed and the weakened dollar,” Gradante explained.
For example, if a C stock in the S&P is an exporter, a weak dollar environment means it’ll be worth more even if its fundamentals aren’t up to snuff. The same is true for an A-stock exporter of course, but that company’s strong fundamentals mean that when the dollar stabilizes, the company will maintain its rightful place in the pecking order, whereas the C-stock company will sink. An unusually low-interest-rate environment is also contributing to weak companies’ unlikely success.
The relative success of weaker companies is hurting active managers and hedge-fund managers alike, but for different reasons. “On the long side, investors might be better off in an exchange-traded fund because it offers the full breadth of all ships rising, rather than an active fund manager who avoids the lower-quality stocks,” and thus underperforming their benchmark, Gradante said. Meanwhile, “hedge funds are outperforming the S&P, but by a lot less than they should be because they’re losing money on the short side,” because hedge-fund managers typically bet against weak companies in the short-term Year to date, the Hennessee Hedge Fund Index returned 4.6%, beating the S&P 500’s 2.3%, but below where it should be, Gradante said.