When an investor is trying to diagnose whether the economy is hurtling towards recession, their first inclination might not be to check the stock market.
They might take a look at recent data, and how it compares to economist expectations. Whether that means employment, housing, or manufacturing, they’re all meaningful indicators.
But sometimes cracks can form that are largely invisible to those who exclusively watch economic data. And when that happens, the stock market is a useful place to look.
Not just the whole market, but one group whose fate is closely linked to whether the economy is in a late-cycle environment: “high-quality” stocks. These are normally defined as the companies that are profitable and self-sufficient to a degree that insulates them from everyday economic churn — and their outperformance relative to the market can be an ominous sign for the health of the economy.
“A standard ‘playbook’ of the cycle tells one to buy stocks with high quality attributes when growth begins to slow,” a Bernstein team led by Inigo Fraser-Jenkins, a senior analyst and the firm’s head of global quantitative and European equity strategy, wrote in a client note. “Looking ahead we think that is the next stage of the cycle that we are set to face.”
The short version of Bernstein’s advice is to simply buy high-quality stocks and watch gains accumulate. However, many of these equities are quite expensive, since other investors have realized the immense value of their businesses and loaded up on shares accordingly.
That presents traders with a Catch-22 of sorts — they should buy high-quality stocks, which may be too expensive for them. Luckily, Bernstein has a solution, which it lays out in detail:
“We look for companies with high tax paid/pre-tax income, companies with ‘low discretionary accruals,’ a low level of accruals as a share of earnings and low three year trailing volatility of changes in consensus EPS,” wrote Fraser-Jenkins.
Note that accruals can refer to either revenue or expense entries, as long as they’re in the absence of a cash transaction. The “discretionary accruals” referenced by Bernstein clearly refer to expenses.
The firm’s overall point is that investors should seek out companies offering sustainable, low-risk profit growth that has very little chance of being derailed in the medium term. And since earnings expansion in these companies will help keep traditional valuation metrics like price-to-earnings (P/E) ratios in check, valuation concerns can be alleviated as well.
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