The stock market’s “flight to crap” faces a big test this week
Analysts say continued outperformance of “low-quality” stocks may depend the July inflation report due tomorrow.
This week could be a crucial one for the “flight to crap,” the evocative moniker Interactive Brokers’ Steve Sosnick bestowed on the market-beating romp we’ve seen in what might be described as “low-quality” shares.
It’s always a bit tricky clearly identifying what we mean by “low-quality.” Sometimes you only know ’em when you see them.
But Goldman Sachs publishes data on several thematic baskets that pass a more quantified muster, from its US Barra Low Quality Indexified basket to other thematically organized slugs of stocks that package up unprofitable tech companies or stocks with high levels of short interest — usually a sign that there’s some fundamental performance issue that’s attracted attention.
As you can see, they’ve all been flying since the market hit its tariff-related closing low on April 8.
But more than one analyst is calling out tomorrow’s CPI inflation report for July as a potential turning point for this trade, suggesting that much of the low-quality run-up is due to the pricing in of Fed rate cuts in the coming months.
If the July inflation report arrives hotter than expected — potentially making the Fed leery of cutting when it meets next month — that could undermine the logic behind the trade, they say.
In a note published Monday, Morgan Stanley’s chief US equity strategist, Mike Wilson, wrote of what might happen should inflation be slightly weak:
“What if we don’t see material signs of inflation pressure in the July CPI report? Bond market pricing of a September cut (currently at a ~90% probability) could rise further. This has the potential to catalyze a more durable rotation to small caps and lower quality stocks should it play out. In other words, we think it makes sense for equity investors to stay nimble around this week’s CPI report as a leadership shift under the surface of the market could take hold depending on the result.”
In a note published Friday, Goldman Sachs equity strategist David Kostin had a similar take:
“We expect the near-term path of economic growth and inflation data will determine the path of the Quality factor during the next few months... low-quality stocks will outperform if the economic growth outlook improves, or if inflation data or Fedspeak indicate a more dovish path of monetary policy than the market is currently pricing while the economic growth outlook remains constant.”
On the other hand, if tomorrow’s CPI numbers, due at 8:30 a.m. ET, come in hotter than expected — economists expect core year-over-year prices to be up 3% — it could spark a sell-off in some of the low-quality winners of recent months. That might make an otherwise sleepy, late summer week a bit more interesting.
