Tuesday, November 24, 2009

>The Stock Picker Has a Job (MORGAN STANLEY)

Key Debate: One of the themes that emerged from our recent Asia summit was the relative rise in interest in company meetings versus macro. The influence of the market (read: macro) on stock returns has been high over the past 18 months. with stockspecific idiosyncratic factors taking a back seat during this period. With the pace of returns likely to slow in the coming months, the key question is whether it is the right time to abandon macro over stock picking.

Macro effect has been in vogue: The fact that macro is the biggest influence in determining the behavior of stocks is most evident in the way the correlation of returns from individual stocks (market effect) with the market has held high over the past 18 months. Conversely, the average relative volatility of the stocks in our coverage universe had plummeted to a decade low. The
rise in market effect tells us that individual stocks were being influenced more by market performance-related factors than by idiosyncratic or non-market performance–related issues. However, we think it is unlikely that the macro effect will rise further and, to that extent, stock pickers may have a better season next year.

Sector correlations are also running high: Another indicator of the dominance of macro is how various sectors are correlated. Inter-sector correlations (across the 45 pairings of sectors using the 10 MSCI sectors) are around their highs, thus neutralizing sector- and stock-level idiosyncrasies. For investors who expect macro factors to continue to be the force du jour, rotating sectors is the way to make money. However, if macro takes a back seat and stock picking comes back into fashion, correlations will fall. Energy seems to be an exception versus history and could be a good hedge against a fall in these correlations.

Micro factors still not in favor but that is usually the time to inflect:: Indeed, the dispersions in fundamentals, valuations and stock returns all appear to be at middling levels. Usually, extreme dispersion is necessary for a very attractive stock picking environment. The bottom line is that the micro environment is not very appealing for stock picking. That said, as growth accelerates in 2010, these micro indicators are likely to change in favor of stock picking.

Trading beta may not be a panacea: Investors who are wary of the market may seek to buy protection by going down the beta curve. However, they need to bear two points in mind: a) beta is constantly evolving – for example, since Jan-08 energy beta has declined whereas materials beta has gone up. We expect more beta from energy in 2010. b) The components of beta (relative volatility and correlation of returns between the stock and the index – i.e., market effect) are as critical in a “beta strategy” as the beta itself.

To read the full report: INDIA STRATEGY