Fishing for quality stocks in turbulent waters

It would be an understatement to say that it’s a strange time in markets. Despite the war in Iran, rising tensions between the White House and the Federal Reserve, and a labor market that’s cooling while inflation remains elevated, the S&P 500 just hit another all-time high today.

This all leaves investors in quite the pickle: Do you go defensive and lean into companies with strong balance sheets, or turn to classic value names, betting that the rally can elevate cheaper, underappreciated gems?

Of course, it’s not a simple either/or. We spoke with Nick Kalivas, Invesco’s Head of Factor and Equity ETF Strategies, to talk about how he sees the landscape, and where there are opportunities in the market.

Our conversation has been edited for length and clarity.

Looking at the market as a whole, where do you see the biggest disconnect today between price and fundamentals?

I’d say it’s still really in smaller stocks. If you think about smaller companies in the S&P 500, or look at the S&P 400 or 600, it really feels like investors have lost faith in smaller companies.

A lot of that is driven by recency bias. These large-cap names have been driving returns, and there’s a widespread belief that they’ll continue to do so. At the same time, there’s a lack of appreciation for where we are in the earnings cycle. Smaller companies are still in the trough or very early innings of an accelerating profit cycle.

So if earnings growth down the cap spectrum actually materializes the way people expect, that part of the market is under-owned and could attract a lot of renewed interest.

In a slowdown, you think of quality as being a winner, because investors want strong earnings and solid balance sheets. Then, historically, when the economy is in more of a recovery mode, a lot of beaten down cheap cyclical stocks rebound. I’m curious, in a more macro sense, where do you think we actually are in the cycle of a slowdown versus recovery?

You bring up a great topic. If I look broadly at profits in the S&P 1500, it feels like small and mid cap sectors, and even parts of the S&P 500, are in the midst of an accelerating profit cycle.

They have a tailwind from the One Big Beautiful Bill, and the data I’ve seen suggests that this kind of fiscal stimulus actually benefits EPS growth more down the cap spectrum than up the cap spectrum. So that’s one factor.

Then you have the Fed rate cuts that have already happened. Those impact the economy with a fairly long lag, and that’s just now starting to kick in. Now, high oil prices have introduced some uncertainty, and geopolitical risks like war may also be holding things back. But it’s interesting—if you look at recent data, like the Empire Manufacturing Survey or the Philadelphia Fed manufacturing survey, both have shown a lot of strength. That supports the idea that manufacturing activity and the cyclical side of the economy are doing well. So overall, it feels like we’re in an upswing, in my view.

A lot of quality companies overlap with some of the really expensive mega cap names, especially given the S&P 500 just hitting another high. Does having a lot of these expensive names in the Invesco S&P 500 Quality ETF (SPHQ) undermine the defensive factor of quality?

Quality has an interesting dynamic here. The quality names have been dominant in the broad indexes, but recently, Mag 7 names—the hyperscalers like Microsoft, Oracle, Amazon, or Alphabet—have actually been removed [from our quality index]. The only Mag 7 that is left right now is Apple, and that’s actually the one that hasn’t seen its capex really change.

If we look at the overlap between the fund and the S&P 500, it peaked at 39% in March of 2024, which is very consistent with your observation, but more recently it’s dropped down to about 20%.

I think from that perspective, it’s a bit differentiated, and it has essentially helped investors mitigate some of the risk related to the hyper scale or capex effect.

If the economy does slow significantly, how do you think investors should allocate between value and quality in their portfolio as a whole?

Historically, quality has been preferable to value in a slowdown. That said, what we see in practice is that a very popular approach is actually to pair quality and value together. Many investors will also add momentum into that mix, and that trio gets a lot of attention in the investment world.

If you’re just isolating value and quality, looking at it in a more two-dimensional way—a lot depends on the investor’s view. Given current earnings expectations and the environment we’re in, it feels like there may be a case to tilt a bit more toward value and slightly less toward quality right now.

That said, the diversification benefits between the two are very clear. And if you’re thinking beyond a tactical horizon—say, the next six months—there’s a strong argument for simply owning both in equal weight and rebalancing periodically.—LB