Market Factors: Beware the high quality stock bubble

In this edition of market factors I’ll detail the extreme levels of dispersion in the U.S. stock market and why it may indicate volatility to come. In section two I’ll outline why I’m considering buying the most terrifying company in existence and the diversion covers a new math prodigy.

Equities

You’ll never guess the return on the median U.S. stock

The most remarkable stat for the week came from Goldman Sachs chief U.S. equity strategist David Kostin who pointed out that the median U.S. stock is down 12 per cent from its 52-week high. The S&P 500 is up 21 per cent over the past year.

The sharp performance dispersion within the U.S. benchmark is indicative of a pattern that could have investors chasing rallies in low quality stocks, counter intuitive as that sounds. Investor assets are so concentrated in a few, high quality companies that companies with weaker balance sheets, lower profit margins and higher earnings volatility may soon be the smart buy for new investor money.

Mr. Kostin uses three-month standard deviation of market sector performance to measure dispersion. Current conditions indicate a level of dispersion that is 90 per cent towards a target that, if hit, implies that high quality stocks will not climb by 10 per cent in the subsequent 12 months.

Investor preference for a narrow number of stocks and themes has led to huge valuation disparities. Mr. Kostin writes, “The top 20% of S&P 500 stocks on quality currently trade at a 57% P/E premium to the lowest quality stocks, a valuation gap ranking in the 94th per centile since 1995”.

Goldman Sachs economists, arguably the most influential team in all of sell-side research, predict sluggish U.S. growth combined with stubborn inflation pressure. This backdrop favours high quality stocks. Mr. Kostin notes, however, that the slow growth/high inflation combination is expected to be temporary and “given the asymmetry indicated by current valuations, we think investors should protect themselves against the potential for a sharp rotation toward low quality if the outlook for economic and earnings growth proves more resilient than feared”.

Buying low quality stocks never seems like a good idea. It might be more useful for investors to note the extreme levels of market dispersion, and guard portfolios against a sharp decline in the higher quality stocks it’s more likely they own.

Stock picking

I might soon own stock in the scariest company ever

I am entertaining the idea of buying the most terrifying company in the world, CRISPR Therapeutics (CRSP-Q), because there are signs that the growth opportunity for the gene-splicing specialists might be completely open-ended.

The company’s Casgevy process to treat blood diseases sickle cell anemia and transfusion-dependent beta-thalassemia is gaining scale. There is research underway to use CRISPR’s gene-splitting technology to target the liver’s production of a protein associated with heart disease. The area is competitive, but CRISPR is also developing a treatment for type one diabetes.

Oncology may turn out to be the most exciting opportunity for CRISPR treatments. Researchers have already used CRISPR to make what are called chimeric antigen receptor-natural killer cells that attack tumors. Other research is underway to modify T-cells to better recognize and attack cancerous tissue. Bespoke cancer treatments – personalized cells to treat cancers – have already proven possible if not yet scalable.

I’m only half kidding when I profess terror about the potential for gene editing. I fully expect the U.S. military to make Captain Americas but what if someone MacGyvers up a centaur only instead of half-man, half-horse, it’s half-man, half-giant tarantula? There seems no limit to imagination.

But if gene editing technology can treat blood diseases, heart disease, diabetes and cancer it seems like massive growth opportunities are on the horizon.

Diversions

Real life Will Hunting

A real-life Will Hunting named Hannah Cairo recently solved a decades old math problem at age 17. This is maddening to me because I was not blessed with similar gifts. I always wanted to be Will Hunting only without the child abuse.

Hannah Cairo (a terrific handle by the way), was homeschooled probably because the high school teacher that could keep up with her doesn’t exist. She mastered calculus at age 11 and was then self-taught with grad school textbooks and university professors her parents hired as tutors.

The Mizohata-Takeuchi conjecture has to do somehow with waves on surfaces and there are professors and groups of mathematicians that have been working to affirm or disprove it for decades. Ms. Cairo disproved it.

The prodigy is now at the University of Maryland because they had the foresight to accept her into graduate school without a high school diploma.

The essentials

Looking for our updates on market movers, analyst actions, stock technicals, insider trades and other daily, weekly and monthly insight? Click here to visit our Inside the Market page.

Globe Investor highlights

Salmaan Farooqui reports on the “emerging consensus” on what to do about home prices

Amber Kanwar details the two big tests for markets this week

Mike Dolan explains why we’ve been looking at the wrong earnings season all along (hint, the tariff impact still lies ahead)

Sid Mokhtari, CIBC’s chief market technician, has produced stock picks this year that have doubled the returns of the TSX. Here’s his top 10 stock ideas for August

What’s up next

Domestic economic news for the upcoming week is a two-part story starting Friday with month-over-month manufacturing sales for June, where economists expect a 0.4 per cent increase. Part two is the June summary of international securities transactions out next Monday.

For Canadian corporate profit results there’s CAE Inc. ($0.202 per share expected) on Tuesday followed by Hydro One Ltd. ($0.503), Metro Inc. ($1.533) and CCL Industries Inc. ($1.15) on Wednesday.

Relevant U.S. data starts with month-over-month CPI for July on Tuesday when economists forecast a 0.2 per cent increase. Producer prices for July are next on Thursday – economists expect a 0.2 per cent increase. U.S. retail sales ex-autos for July will be reported on Friday and a 0.3 per cent month-over-month gain is expected. Month-over-month industrial production results for July are out Friday and economists expect a flat reading.

U.S. corporate results include Cisco Systems Inc. on Wednesday ($0.979 per share forecast) and Deere & Co. ($4.703) and Applied Materials Inc. ($2.355) follow on Thursday. Cybersecurity specialists Palo Alto Networks Inc. (0.885) will post profits next Monday.

See our full earnings and economic calendar here