◾ The Quality factor, a long/short basket pair representing the outperformance of firms with high returns on equity, low leverage, and stable earnings relative to a basket of stocks with the opposite financial metrics, has jumped by 4% since last week. However, that rebound comes on the heels of a 17% drawdown since July, the factor’s sharpest decline in recent years outside of late 2020 and early 2021.
◾ The initial Quality unwind this summer coincided with an improvement in the equity market’s pricing of economic growth and a decline in interest rates. Consistent with these shifts, the Quality factor sell-off has been driven primarily by the outperformance of “low quality” stocks with volatile earnings and low profitability rather than by the underperformance of “high quality” firms. However, the rotation away from Quality has run more than 10% beyond what its typical macro drivers would have indicated.
◾ A violent short squeeze in recent months helps explain the exceptional underperformance of Quality. A basket of the most shorted stocks has doubled since the market low in April and rallied by more than 30% since early September. The Quality factor typically struggles during short squeezes in part because “low quality” stocks tend to be popular short positions.
◾ Although the underperformance of Quality has been severe, we do not expect a major rebound for the factor in the near future. From a macro perspective, GS expectations for modest economic growth acceleration alongside continued Fed cuts give little reason for investors to rotate back to the perceived safety of high quality stocks. From a fundamental perspective, the P/E valuation gap between the high quality long leg of the factor (25x) and the low quality short leg (12x) registers near the wide end of the range of the last few years. From a flows perspective, short interest remains above average, signaling room for the recent squeeze to continue.
◾ While the Russell 1000 large-cap index stands at an all-time high, the median constituent in the index trades 13% below its high. At a micro level, the recent Quality unwind has created potential opportunities to buy high quality stocks at discounted prices. Exhibit 11 consists of Russell 1000 constituents of the High Quality (GSX1BFQL) and Quality Compounders (GSXUCOMP) baskets that trade at least 10% below their respective 52-week highs and carry P/E multiples below their 5-year medians. The median stock in the screen is expected to deliver EPS growth of 11% in 2026 and has experienced no major negative EPS revision in recent months despite declining in price.
A near-term rebound of the quality factor is not expected