“They are like a person building a house, who dug down deep and laid the foundation on rock. When a flood came, the torrent struck that house but could not shake it, because it was well built” -Luke 6:48
In my recent posts, I discussed the dependence of stocks on Quantitative Easing (QE) from the Federal Reserve and identified a group of high quality stocks that overcame the downdraft that afflicted the overall equity market following the end of QE1 from April 2010 to August 2010. I will be back soon with a look at asset classes outside of the equity market. In the meantime, I wanted to revisit the stock discussion still looking ahead to the projected end of QE2 on June 30, 2011.
Quality, size and stability will likely be critical factors to consider for stocks when QE finally comes to an end.
As a recap, the S&P 500 Index plunged over -17% in a matter of weeks following the end of QE1 in April 2010. In my previous post, QE-Proof Stocks for Summer 2011, I identified 19 stocks that performed relatively well during this “QE Pause” from April 26, 2010 to August 27, 2010 when the Fed definitively announced that QE2 was on its way. Stocks were selected on the following critera:
Size – Member of the S&P 500 Index (US Large Caps held up considerably better than Mid-Caps, Small Caps and Non-US Stocks)
Quality – S&P Quality Ranking of A- or better
Stability – Cumulative closing price decline during the the QE Pause period from April 26, 2010 to August 27, 2010 of less than -10% and Intraday price decline of less than -11%
To expand on this analysis, I wanted to subject the Quality constraint to further tests. After all, there are 375 stocks in the S&P 500 Index that have a S&P Quality Ranking of B+ or lower.
What was notable in this analysis is that very few stocks beyond the high quality universe held up during the QE Pause. Overall, only 14 stocks out of the remaining 375 in the S&P 500 Index met the Stability criteria. I have listed these below, as I’ve added them to my original list of 19.
Marathon Oil (MRO)
Auto Zone (AZO)
O’Reilly Automotive (ORLY)
HJ Heinz (HNZ)
Dr. Pepper Snapple (DPS)
Reynolds American (RAI)
Dominion Resources (D)
Consolidated Edison (ED)
Xcel Energy (XEL)
A few things are notable about this list. First, 11 of the 14 listed above have an S&P Quality Ranking of B+, which is the highest possible quality ranking for those stocks not included in the original list of 19. This reinforces the importance of quality in a non-QE environment.
What is also notable, although less surprising, is the defensive nature of the names on the combined list of 33 stocks. More specifically, 14 names are from the Consumer Staples sector and another 6 stocks are from the Utilities sector. With over 60% of stocks coming from two sectors, it is also worthwhile to consider the Sector ETFs in this context. A look at the Consumer Staples Select Sector SPDR (XLP) and Utilities Select Sector SPDR (XLU) show that both also meet the Stability criteria outlined above.
So how well did these quality stocks perform following the end of QE1? The chart below shows the cumulative performance of an equal weighted portfolio of the 33 stocks identified versus the overall S&P 500 Index. Overall, while the S&P 500 Index experienced a maximum decline of -17% and was still down -15% by the end of August, the equal weighted 33 stock portfolio experienced a maximum decline of only -3% in generating a +4% advance during the same period.
Of course, history will not necessarily repeat itself with these 33 stocks when QE2 comes to an end. While some will hold up again the second time around, others will likely falter due to new forces at work. And some stocks that trailed after QE1 will shine following QE2. So while the individual names may differ the next time around, the overall focus on quality, size and stability in stock portfolios provides the ability to protect capital with greater probability once QE2 comes to an end.