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.

 

 

Register or login for access to this item and much more

All On Wall Street content is archived after seven days.

Community members receive:
  • All recent and archived articles
  • Conference offers and updates
  • A full menu of enewsletter options
  • Web seminars, white papers, ebooks

Don't have an account? Register for Free Unlimited Access