During the past five weeks, the US stock market has retraced nearly all of August’s 11% sell-off. On one level, that might read as some kind of an “all clear” signal. Indeed, many technical indicators are now constructive: The VIX is below 20, the yield curve has steepened, oil prices have stabilized, the dollar has eased, high yield credit spreads have tightened and the S&P 500 is back above its 200-day moving average (see chart).

Even so, we remain cautious that perhaps the market’s snapback is not quite what it seems. Heading into October, sentiment was extremely negative, and so aggressive short and defensive positioning was bound to reverse if macro data stabilized and third-quarter earnings came in without massive disappointments. Still, lingering concerns around earnings resilience are legitimate, especially if global growth remains tepid, capital investment continues to be lackluster, rising credit costs reduce the efficacy of share repurchases and mergers-and-acquisitions (M&A) strategies and wage pressures weigh on profit margins. While investors who held tight through the turmoil have likely recouped some of their losses, underlying trends have been less benign. Indeed, we have seen powerful sector rotation and reversals in price momentum.

Health Care Pullback

One of the most painful turns has been the sharp pullback in biotechnology and other health care stocks. Although health care has been the sector-level poster child for this cycle’s growth-style bias—understandable when GDP growth, inflation and interest rates are low—the reversal raises questions about whether market leadership is about to shift. What’s more, financials, which should have benefitted from the steepening yield curve, are lagging while consumer staples and services, widely expected to be victims of the strong dollar, are rallying. In such circumstances, portfolio construction is challenging and not easily summarized under the usual banners of cyclical versus defensive, growth versus value, large cap versus small cap or multinational versus domestic. For the first time in this cycle, winners and losers are being determined at the company level.

For US equity investors, the Global Investment Committee is navigating this environment by advocating stock selection on idiosyncratic risk and taking a barbell approach between secular growth leaders and cheap dividend growers, with an emphasis on high-quality companies. This elevates the importance of sustained, high free cash flow as a driver of success in this next phase of the market cycle, in which gains should largely rest on skillful capital deployment instead of margin expansion or higher price/earnings multiples (P/Es).

Earnings Season

Third-quarter earnings reports illustrate the relevance of quality as a theme. As of Oct. 30, 339 S&P 500 companies, representing 77% of market capitalization, have reported. As anticipated by Adam Parker, Morgan Stanley & Co.’s chief US equity strategist, earnings estimates coming into the quarter were too pessimistic and, thus, 38% beat estimates and only 9% came in below. Those surprising to the upside did so by an average 5.1%. Revenue growth has been more challenged, with only 27% beating lackluster expectations.

While these results may seem in line with prior quarters, what is different is how sectoral dispersion has shifted; the differences in earnings surprises from high to low across sectors have been relatively narrow while the differences within sectors have been quite wide. With limited pricing power and tepid top-line growth, the quarter’s best profit reports have cutting and the balance sheet and cash flow capacity that allows for share repurchases and M&A. In addition, companies that are holding and gaining market share through innovation, product differentiation and competitive distribution models are distancing themselves from those stumbling under the weight of the macroeconomic cycle.

Credit Costs

Credit costs play a role, too. With nearly 80% of corporate financing getting done in public markets, the widening of credit spreads has had a more variable impact on companies, depending on balance sheet leverage. While high-quality companies have had limited constraints on their ability to execute accretive share repurchases and M&A, others are increasingly experiencing credit downgrades, which have doubled this year from 2014’s low. Still, where companies fall on the credit cost spectrum is not easily classified; some are among the fastest in secular growth and others reside among the more value oriented cyclicals.

While the earnings performance of companies with high cash flow has begun to diverge from the broader market, importantly, valuations have not; intrasector P/E dispersion remains at extremes. This creates opportunities, according to Parker. He noted that while high-quality stocks outperformed low-quality stocks on a risk-adjusted basis in September and the 11.8% performance differential is the widest performance spread since December 2008, there is still plenty of room for high quality to make relative gains. On a free-cash-flow basis, high-quality versus low-quality stocks are at a 350-basis-point spread, the most extreme since 2000. He notes that high-quality stocks have typically traded at a 10% discount to low-quality stocks, but that discount is now 23%. What also makes this compelling, he adds, is that earnings expectations for the high-quality cohort are much more modest and thus suggest higher future achievability. Furthering the valuation argument, he goes on to say that US high-quality stocks are also much cheaper relative to their high-quality counterparts in Europe.

Falling Correlations

A final point around our quality preference relates to market positioning. Active managers have a tendency to own quality stocks and our view is that active management will be increasingly effective. One of the most important success factors for active managers is falling correlations between and among companies, sectors and geographies and, indeed, correlations have begun to fall (see chart). Interestingly, according to Parker’s research, hedge fund managers are currently upside down on quality factor positioning; their ownership of low-quality stocks is near the highs of the cycle.

All told, we are focused on quality as defined by free cash flow. To put that into practice, watch for continued dispersion of earnings results and valuation to separate winners from losers. On a sectoral balance, we suggest balancing US equity exposure between high-growth secular winners in tech, consumer discretionary and health care and cheap high-quality cyclicals with solid dividend-growth potential, specifically in financials and diversified industrials.