Let’s face it – this bull market is old. Very old. And forgive me for being harsh, but it also might die soon. While I don’t believe bull markets die of old age, I do think that the longer an economic and market growth cycle runs, the more vulnerable it becomes to fundamental breakdowns – tightening credit conditions, massive waves of debt defaults, inflation pressures, geopolitical conflicts, just to name a few.

I’m not saying it’s time to go defensive. But I do think it could make good sense for investors to begin considering how to posture portfolios for a late cycle, mature bull market. In my opinion, that means shifting your portfolio management mindset to focus on quality.

Why Quality, and What Does that Mean?

Perhaps the best way to grasp the ‘quality’ concept is to think in high-level terms about how different types of stocks perform at different times in a market cycle.

Generally speaking – and based on my own experience – I’ve have found that small-cap stocks tend to outperform early in an economic cycle. In my view, this happens as capital and liquidity return to the marketplace, and as ‘animal spirits’ drive fresh investment, spending, and risk taking. I think domestic, small-cap stocks tend to benefit the most in this environment, and from the strong spurts of growth that tend to occur right after a recession ends.

As an economic expansion hits stride and eventually matures, we often find that credit starts to tighten, margins start to fall as costs rise, and consumers start to spend less – all factors that hurt small-caps, in my view. When the economy starts to see those types of changes – which I would argue is taking place today – it makes companies with stable earnings, healthy cash flows, and strong balance sheets look attractive by comparison. And that’s what I mean by ‘quality.’

For investors, looking for quality stocks means analyzing companies for three features, in my view:

  • Stable year-over-year earnings growth
  • Low levels of leverage (debt to asset ratios)
  • Deep product/service pipelines and strong management

Many long-term dividend paying stocks tend to fall in these categories, and often times it means buying ‘boring’ stocks that may not offer the most attractive risk-adjusted returns. At the end of the day, however, boring doesn’t matter if the company is positioned to succeed over the long-haul. Having strength in all three categories above means a company can survive – and even potentially do well – in adverse macroeconomic conditions, in my view.

An at-a-glance look at this bull market bears out this small-cap versus quality argument. In the first full year of this bull market, 2010, small-cap1 was among the best performing categories of stocks, delivering a return of +26.9%. ‘Quality’ stocks, as defined by MSCI,2 also did well (+12.6%) but not nearly as good as small-caps.3

Fast forward to 2017, which again I would argue brings us to the final innings of this bull market, and we see a near-symmetrical reversal of leadership. Last year, quality stocks returned +26% while small-caps were up +14.6%. In my view, this shift in leadership happened as investors have shifted on the risk spectrum to favor more earnings-reliable, larger-cap corporations. A trend I think could continue in 2018.

Bottom Line for Investors

This shift to focus more on quality may not involve the need for wholesale changes to a portfolio strategy – a well-diversified portfolio should probably already have several quality names in it. But, it could warrant a fresh review of their portfolio holdings, to see if the companies you own are positioned to do well in more difficult macroeconomic conditions. Sometimes the best offense is a good defense.


1 Small cap stocks are represented by the Russell 2000 Index, which is a small-cap stock market index of the bottom 2,000 stocks in the Russell 3000 Index.
2 Constituents of the MSCI Quality Index are selected based on three main variables: high return on equity, stable year-over-year earnings growth, and low financial leverage.
3 J.P. Morgan https://am.jpmorgan.com/us/en/asset-management/gim/adv/insights/guide-to-the-markets/viewer


Past performance is no guarantee of future results. Inherent in any investment is the potential for loss.

Zacks Investment Management, Inc. is a wholly-owned subsidiary of Zacks Investment Research. Zacks Investment Management is an independent Registered Investment Advisory firm and acts as an investment manager for individuals and institutions. Zacks Investment Research is a provider of earnings data and other financial data to institutions and to individuals.

This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. Do not act or rely upon the information and advice given in this publication without seeking the services of competent and professional legal, tax, or accounting counsel. The information contained herein has been obtained from sources believed to be reliable but we do not guarantee accuracy or completeness. Publication and distribution of this article is not intended to create, and the information contained herein does not constitute, an attorney-client relationship. No recommendation or advice is being given as to whether any investment or strategy is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of herein and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole.

Any projections, targets, or estimates in this report are forward looking statements and are based on the firm’s research, analysis, and assumptions. Due to rapidly changing market conditions and the complexity of investment decisions, supplemental information and other sources may be required to make informed investment decisions based on your individual investment objectives and suitability specifications. All expressions of opinions are subject to change without notice. Clients should seek financial advice regarding the appropriateness of investing in any security or investment strategy discussed in this presentation.

Certain economic and market information contained herein has been obtained from published sources prepared by other parties. Zacks Investment Management does not assume any responsibility for the accuracy or completeness of such information. Further, no third party has assumed responsibility for independently verifying the information contained herein and accordingly no such persons make any representations with respect to the accuracy, completeness or reasonableness of the information provided herein. Unless otherwise indicated, market analysis and conclusions are based upon opinions or assumptions that Zacks Investment Management considers to be reasonable.

Any investment inherently involves a high degree of risk, beyond any specific risks discussed herein.