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Our Outlook for the Market

Why 'quality' has been lagging and what may turn it around.

Pat Dorsey, 09/28/2010

At the end of the third quarter, the overall song remains the same as it has been for most of 2010--the market overall is fairly valued, while mega-caps as a group look somewhat cheap, and some high-quality mega-caps look very cheap.

Because we at Morningstar have been singing the "quality is on sale" song for quite some time--and the asset class has not exactly been setting the world on fire--I thought it would be worth addressing the topic directly, in three parts.

  1. What's behind the continued underperformance of mega-cap/high-quality U.S. equities?
  2. What might need to happen to reverse this trend?
  3. Just how cheap are mega-caps, anyway?

Why Has 'Quality' Been Lagging?
I've seen all sort of theories floated to answer this question, but the one that makes the most sense to me is pretty simple: hindsight bias and performance chasing on a truly massive scale.

"Brand name" blue chips like Johnson & Johnson JNJ, Coca-Cola KO, and Wal-Mart WMT have seen 10 years of steady multiple compression, and the investor tendency to gravitate away from underperforming asset classes is extremely well documented.

Marginal investment dollars are thus flowing into bonds, commodities, and emerging markets due to their superior performance over the past several years--and those dollars are coming out of domestic equities. I don't think it's any more complicated than this.

I asked a few friends of mine in the brokerage community, as well as some portfolio managers at large fund shops, whether I was oversimplifying. They agreed that rearview mirror driving has been a huge factor. One wrote to me:

"A 10-year chart on these names won't be a great sales tool for a broker or a financial planner who sits down and shows them what the asset they are recommending has done for the last decade. This same effect probably explains at least part of the bond bubble that exists in the short/intermediate part of the Treasury curve. Sloppy money chasing yesterday's performance. In short--investors are 'blaming' these companies for what they did to them over the past decade, and they have sworn off a repeat."

You can see the underperformance of mega-caps in the chart below, which shows the excess returns of the S&P 100 relative to the S&P 500 over the past 20 years, for rolling 12-month periods. (Green=S&P 100 outperforming.) Except for a brief period of mega-cap outperformance in 2008-09 when risk aversion was high, the largest companies have underperformed the overall index pretty continuously since the late-'90s bull market.

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