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Quality at a premium in equity market retreating into earnings season

“Investors see that there’s some increased uncertainty,” said John Conlon, chief equity strategist at People’s United Wealth Management.

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With an 18-month profit recession in the books and Alcoa Inc. plunging after reporting results that fell short of analysts' estimates, it's understandable that investors are starting to avoid companies whose earnings have proven the least predictable.

Instead, they're loading up on stocks whose record of income growth and balance-sheet strength lands them in the investment category known to quants as "quality," a group that has seen record inflows in recent days, going by an iShares exchange-traded fund that tracks it. That security fell along with the broader market Tuesday as the S&P 500 Index declined 1.2 per cent to 2,136.73.

Safety is back in vogue with analysts forecasting S&P 500 profits will decline for a sixth straight quarter in the July-to-September period. Though it's early, results have been disappointing so far, with Alcoa tumbling 11.4 per cent Tuesday after reporting a profit that was 2 cents short of analysts' per-share estimates.

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Among the beneficiaries of earnings season skepticism have been smart-beta ETFs that facilitate tailored bets on investment characteristics such as high dividends and low volatility. Specifically, traders are pouring money into securities tracking the quality factor as a way to pluck out companies best suited to escape the profit recession unscathed.

"Investors see that there's some increased uncertainty," said John Conlon, chief equity strategist at People's United Wealth Management in Bridgeport, Conn., which oversees $5.5-billion (U.S.). "The earnings season is now going to be grabbing attention for the next three weeks. There's going to be focus more and more on those companies that have higher quality earnings, strong balance sheets and stronger cash flow."

The iShares MSCI Quality Factor ETF absorbed $350-million over the past seven days, the most the fund has ever received in such a period since its creation in 2013, Bloomberg data show. A Dow Jones-compiled index that buys quality companies and shorts low-quality companies just wrapped up its longest winning streak in nine months.

Companies in the BlackRock Inc. portfolio include Johnson & Johnson, its largest holding, which topped analysts' estimates last quarter and is expected to report profit growth of 18 per cent in the September period. Technology and health-care companies are the biggest sector holding. Analysts expect profits in those groups to rise more than 3.5 per cent even as S&P 500 income as a whole declines.

"Alcoa is always the first off and seen as a bellwether for industrial demand," Chris Gaffney, president of world markets at St. Louis-based EverBank, said by phone. "People need to see strong earnings, especially with the thought that rates will start moving higher. The environment for companies is going to get less accommodating. The drivers today and going forward are going to be earnings."

Traders boosted odds for a December interest rate hike by the Federal Reserve to almost 68 per cent, from 64 per cent on Friday and about 50 per cent two weeks ago as encouraging data signalled that the U.S. economy is strong enough to cope with higher borrowing costs. Chicago Fed President Charles Evens told reporters in Sydney that a December move "could be fine," after arguing in a speech to keep rates low until core inflation moves higher.

The S&P 500 trades at more than 18 times estimated earnings, compared with a 15.6 average for the past five years. Now that Alcoa has unofficially kicked off the earnings season, investors will be looking for signs of sustainable profit growth at S&P 500 members. While analysts forecast a 1.6 per cent contraction in third-quarter profits at the gauge's members, U.S. firms have beaten projections by an average margin of 3.6 percentage points in the past five years.

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