Let’s start this week’s commentary with a hypothetical scenario: A person you trust says they have two stock picks for you. Both stocks are expected to rise in price. The charts for each stock are showing similar formations and the recent news seems equally positive. You only have enough available cash to buy one of the two stocks. Which one do you choose?

Some of you will consider the valuations and opt for the less expensive stock. Others may look at the dividend. Portfolio diversification and volume would also be likely considerations. What about quality? Would you consider each stock’s underlying fundamental traits when deciding which one to buy?

I would suggest you should. While factors such as valuation, price momentum and dividends get more attention, quality matters too. Quality refers to a company’s underlying traits: Fiscal strength, profitability and the ability to return capital to shareholders. All things being equal, higher-quality companies offer more upside potential than lower-quality companies. Quality companies have more traits associated with higher returns and fewer traits associated with disappointing returns.

I personally consider a company’s quality traits because I believe in having the odds in my favor. I never know in advance how well a stock will actually perform when I buy it (nor does anybody else), but I do know lower-quality stocks have a bigger chance of falling in price. As Charles Ellis once wrote in the AAII Journal: “The secret to success is simply not making big mistakes.”

Quality should never be confused with a price increase. A stock whose price has risen since purchase may be considered to have been a good investment, but that does not make it a quality stock. Every year there is a group of stocks that rise on hype and optimism, but not much else. Every year, there are also many people who win sizeable jackpots by playing slot machines. There are far more people who lose money—a lot of it—on both.

Rather, quality refers to the underlying fundamental strength of the company. Does it generate more cash than it uses through its normal business operations? Does it efficiently turn its assets and shareholder dollars into sales and earnings? Are shareholders being rewarded with dividends and share repurchases? Is debt being kept at a reasonable level? Are earnings growing? Does management avoid using aggressive accounting techniques?

There isn’t a consensus definition for what precisely defines quality when it comes to investing, but there are commonalities in approaches. Companies should realize profits and/or positive levels of cash flow. They should be more efficient in their use of assets. Some practitioners look for reasonable levels of debt or at least decreasing levels of debt. I prefer a company to be friendly to its shareholders.

What you want to avoid are companies that are risky. It’s a simple matter of understanding the odds. Unprofitable companies, those failing to operate more efficiently and/or those that aren’t realizing positive cash flow are at greater risk of costing you money. While some of these stocks do go up in price, most don’t. So, regardless of whether you are a value investor, a growth investor, a momentum investor or a chartist, it can make a lot of sense to include some quality measures in your investing strategy.

• Piotroski: High F-Score Screen – Joseph Piotroski used a variety of criteria to separate junk companies from quality companies among deep-value stocks.
• What Works: Key New Findings on Stock Selection – James O’Shaughnessy shared the strategies he uses to identify quality and financial strength (along with value).

• Polar Opposite: MAGNET Complex Goes From Bottom to Top in 2017 – Most of the AAII stock screens realized gains last year, with 25 besting the S&P 500, as Wayne Thorp discusses in our annual review.
• Model Shadow Stock Portfolio: Implementing the New Four-Year Sell Rule – A new rule designed to get rid of long-term underperformers prompted the replacement of four stocks.

First-quarter earnings season will “officially” start next week with Dow Jones industrial average component JPMorgan Chase & Co. (JPM) reporting on Friday. Six other members of the S&P 500 will also report: Acuity Brands Inc. (AYI) on Tuesday; Lennar Corp. (LEN) on Wednesday; Delta Air Lines (DAL) on Thursday; and BlackRock Inc. (BLK), PNC Financial Services Group Inc. (PNC) and Wells Fargo & Co. (WFC) on Friday.

The week’s first economic reports will be the November JOLTS report, released on Tuesday. Wednesday will feature December import and export prices. The December producer price index (PPI) will be released on Thursday. November business inventories, December retail sales and the December consumer price index (CPI) will be released on Friday.

Five Federal Reserve officials will make public appearance: Boston president Eric Rosengren on Monday and Friday; Atlanta president Raphael Bostic on Monday; Minneapolis president Neel Kashkari on Tuesday; and Chicago president Charles Evans and St. Louis president James Bullard on Wednesday.

The Treasury Department will auction $24 billion of three-year notes on Tuesday, $20 billion of 10-year notes on Wednesday and $12 billion of 30-year bonds on Thursday. You can buy Treasury securities directly from the government at TreasuryDirect.gov.

Optimism among individual investors jumped to its highest level in more than seven years, according to the latest AAII Sentiment Survey. Pessimism, meanwhile is at its lowest level in more than three years.

Bullish sentiment, expectations that stock prices will rise over the next six months, surged 7.1 percentage points to 59.8%. Optimism was last higher on December 23, 2010 (63.3%). The historical average is 38.5%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, pulled back by 2.0 percentage points to 24.7%. Neutral sentiment is below its historical average of 31.0% for a fifth consecutive week.

Bearish sentiment, expectations that stock prices will fall over the next six months, fell 5.1 percentage points to 15.6%. Pessimism was last lower on November 6, 2014 (15.1%). The historical average is 30.5%.

Optimism has now risen by a cumulative 30.5 percentage points since hitting a near-term bottom of 29.3% on November 16. Over the same seven-week period, pessimism has fallen by a cumulative 19.6 percentage points.

There have only been 46 weeks with a similar or higher bullish sentiment reading recorded during the more than 30-year history of our survey. The S&P 500 index has a median six-month return of 0.5% following those previous readings, up slightly more times than it has been down.

Historically, the S&P 500 has realized below-average and below-median returns over the six- and 12-month periods following unusually high bullish sentiment readings and unusually low bearish sentiment readings. The magnitude of underperformance has been greater when optimism is unusually high than when pessimism has been unusually low. In both instances, returns have still been positive on both an average and median basis. An updated table with the historical readings can be found in my Investor Update commentary from three weeks ago.

Some individual investors are encouraged by the record highs for the major indexes, the tax cuts and/or the Federal Reserve’s decision to continue raising interest rates at a gradual pace. Other individual investors are concerned about the possibility of a pullback or a more severe drop occurring. Also affecting investor sentiment are earnings growth, economic growth, valuations and the lack of volatility. Washington politics remain at the forefront of many individual investors’ minds.

This week’s special question asked AAII members how big a percentage gain or loss the S&P 500 will realize in 2018. Nearly two out of five respondents (37%) expect the large-cap index to rise between 6% and 10%. An additional 13% of respondents predict the S&P 500 will realize a gain of between 1% and 5%, 14% expect an increase of between 11% and 15% and 7% think the index could rise by 16% or more. Tax reform was the most common reason given for the optimism, followed by economic growth. A little under 7% of respondents think the S&P 500 will end 2018 down by single digits, while 10% believe the index could incur a double-digit percentage drop. Many respondents anticipate greater volatility with a pullback occurring at some point during the year.

Here is a sampling of the responses:

• “8% gain. Continued global economic expansion and the U.S. tax cut will likely push equity prices up.”
• “Tax reform should boost the S&P 500 by 15%.”
• “Tax reform helps, but the market is already ahead of itself. I’d say 6%.”
• “I estimate a 10% increase by mid-year, but a pullback late in 2018 with further interest rate increases.”
• “5%. My guess is as good as anyone’s. Volatility will increase.”
• “It will dip in the 10% range as some of the many events that could provide a catalyst for a drop finally impact the market.”

Bullish: 59.8%, up 7.1 points
Neutral: 24.7%, down 2.0 points
Bearish: 15.6%, down 5.1 points


Bullish: 38.5%
Neutral: 31.0%
Bearish: 30.5%

Individual investors ended 2017 with their largest exposure to equities in 16½ years, according to the December AAII Asset Allocation Survey. At the same time, cash allocations fell further.

Stock and stock fund allocations rose 3.4 percentage points to 72.0%. Equity allocations were last higher in July 2000 (74.0%). December was the 57th consecutive month that equity allocations were above their historical average of 60.5%.

Bond and bond fund allocations declined 2.6 percentage points to 15.0%. Fixed-income allocations were last at this level in June 2017. The historical average is 16.0%.

Cash allocations declined 0.8 percentage points to 13.0%. Cash allocations were last lower in December 1999 (12.0%). December was the 73rd consecutive month that cash allocations were below their historical average of 23.5%.

There have only been 38 months with equity allocations at or above 70% during the 30-year history of our asset allocation survey. Last month’s reading is partially a reflection of the ongoing bull market in equities and last year’s high returns for stocks. These factors combined have boosted the value of stock holdings.

Also playing a role are low interest rates and increased optimism among individual investors about the short-term direction of the stock market. Bullish sentiment in our weekly Sentiment Survey ended the year at an unusually high level of 52.6%.

Last month’s special question asked AAII members how their current allocation compares to what they expected it to look like at the start of 2017. Slightly more than half of all respondents said their allocations were close to what they had anticipated. Approximately 25% of all respondents said they had more exposure to equities than they expected. Nearly 14% said they have more cash than anticipated.

Here is a sampling of the responses:

• “About the same as I tweaked it during the year.”
• “More stocks than predicted. I did not rebalance, just saw my stock holdings increase due to the market rise.”
• “More cash than expected due to the overvalued market.”
• “About where I expected.”
• “More in stocks and less in cash than I had anticipated. I need to rebalance.”

• Stocks and stock funds: 72.0%, up 3.4 percentage points
• Bonds and bond funds: 15.0%, down 2.6 percentage points
• Cash: 13.0%, down 0.8 percentage points

• Stocks: 32.4%, up 3.4 percentage points
• Stock funds: 39.6%, up 0.1 percentage points
• Bonds: 2.9%, down 1.0 percentage points
• Bond funds: 12.0%, down 1.7 percentage points

Take the Asset Allocation Survey.

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