In a down market marred by exceptional uncertainty, high-quality stocks should be a dead certainty to outperform, as investors seek out safer investments, but that hasn't happened this year. To the continued bewilderment of value-driven investors, high-quality stocks are cheap relative to the broad market. How to explain this bizarre phenomenon and, more importantly, is it a bounty or a bear trap?

How cheap is cheap?
Here's just one illustration of the underpricing of "quality": The broad Morningstar U.S. market index is valued at 15.4 times earnings. Meanwhile, the Morningstar Dividend Leaders index -- a good proxy for high-quality stocks -- commands just 13.1 times earnings, or a 15% discount.

The Dividend Leaders index is no ordinary set of stocks: It contains the 100 highest-yielding stocks with a consistent dividend record and the ability to maintain payouts. These are the elite ranks of corporate America with names such as DuPont (NYSE: DD), Eli Lilly (NYSE: LLY), and ConocoPhillips (NYSE: COP).

2 explanations for cheap
In his most recent monthly commentary, Jeremy Grantham of asset manager GMO offers two possible explanations for blue chips' cheapness: the aging of baby boomers and the "Yale effect."

  • Boomers aging: As an increasing proportion of the population nears retirement, Grantham suggests that they are beginning to substitute the stocks in their pension funds with bonds, which pay a fixed income. At that stage in their investing life, those stocks are most likely high-quality, rather than speculative names. As the flow of selling from these portfolios increases, it naturally puts pressure on prices.
  • The Yale effect: Yale's endowment has an exceptional long-term investing record: Over the 10-year period ending in June 2009, the fund gained 12% per year while the S&P 500 treaded water. Under the direction of David Swensen, the fund was arguably the first endowment to diversify away from traditional asset classes (stocks, bonds) into alternative investments (hedge funds, private equity, commodities, real estate).

    Nothing attracts imitators like success and, over the years, numerous university endowments -- as well as pension funds and other investors -- have adopted what has become known as the "Yale model" and jumped headlong into alternatives. This shift of money away from stocks would have hit blue-chip stocks particularly hard, since they were the bedrock of institutional investors' share portfolios.

Betting on quality: Can these trends reverse?
Let's assume Grantham's explanations are on the mark and explain the bulk of the underpricing of the high-quality segment. If we want to take advantage of it, we need to be confident that these factors will reverse or that other countervailing factors will emerge to close the gap in valuations. Is that likely? Let's take a look at each in turn:

Unfortunately, an aging population means the first trend is unlikely to reverse; boomers will continue to retire in increasing numbers and replace their stock holdings with bonds.

However, rolling back the Yale effect is much more likely. Swensen himself said last year that most endowments shouldn't try to be like Yale. Many institutional investors were burned during the crisis by illiquid alternative investments. Singapore's sovereign wealth fund is now re-examining the suitability of the Yale model. The same reappraisal will undoubtedly take place across the industry. If the shift out of stocks reverses, high-quality stocks -- which are generally very liquid -- should be particular beneficiaries.

Is China a new source of demand for stocks?
What about new sources of demand for high-quality stocks? It's possible that China could fill that role. There are indications it is becoming increasingly interested in owning U.S. stocks.

At the beginning of the year, one of China's state investment vehicles, the China Investment Corp., filed a statement of its holdings with the Securities and Exchange Commission for the first time. While the total amount in question is trifling ($9.6 billion), the list does provide some insight into their investing preferences, and blue-chip stocks are well-represented, including Visa (NYSE: V), Pfizer (NYSE: PFE), MetLife (NYSE: MET), and Abbott Laboratories (NYSE: ABT).

$200 billion in buying power!
Stocks certainly offer an attractive alternative to low-yielding U.S. government bonds when you are managing $2 trillion in foreign exchange reserves and you have a long time horizon. China's State Administration of Foreign Exchange is a conservative institution, so blue chips would likely be big winners of a raised allocation to stocks. Arthur Kroeber, an economist at Dragonomics in Beijing, estimates that the central bank could be allowed to invest up to 10% of its reserves into equities, which amounts to potential buying power of more than $200 billion!

Value wins out (eventually)
Grantham's explanations of the forces holding blue-chip stocks down are unproven, but they are definitely plausible and, as he points out:

Remove the pressure even for a short while and the normal equilibrium will quickly be restored. In this way, quality stocks might possibly spend much of the next several years underpriced, but from time to time will bounce back to fair value. This is all that patient investors need.

Why the wait isn't so bad
"Patient" isn't a superfluous qualifier here. I continue to believe in the "high quality" theme, but I recognize that it could take some time to play out. In the meantime, investors can take comfort that these stocks are much better protected in the event of a market correction, and if they happen to pay a healthy dividend, it certainly takes some of the sting out of the wait.

Fool contributor Alex Dumortier has no beneficial interest in any of the stocks mentioned in this article. Pfizer is a Motley Fool Inside Value pick. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.