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Morgan Stanley has come up with a quantitative ‘contrarian’ indicator to time stocks, based correlation between the “broad market” returns and the Sensex returns.
There are many styles and classes of investing. Depending on your personality, preference and skill set, you could either be a “bottoms-up investor” or a “top-down investor”. What is the difference between the two? In the former, also known as stock-picking, the process of investing starts at the bottom-most level or the stock itself. You start off by choosing a company, any company, and analysing it using fundamental yardsticks. On the other hand, top-down investing one starts from the ‘top’. For example, you analyse the economic climate, select what which sectors are doing well, then select few stocks from the specific sector. In both methods, fundamental analysis is used.
The Asian division of Morgan Stanley Research has advocated, in its latest research report titled “The Best for Stock Picking Is Over”, macro approach to investing rather than bottoms-up style of stock picking. The report said, “Since their peak in January 2012, correlations have declined, but not to levels that historically have signified an opportunity to open up sector positions. In short, we are somewhere between the macro and micro trade but no longer firmly in stock-picking territory.”
The truth is that stock picking, or bottoms-up investing, always work, and always will, if the investor is willing to put in the hard work and effort to identifying key stocks (witness for example the performance of stocks recommended in Street Beat section of Moneylife: Wim Plast: Outstanding performer;Narmada Gelatines: Superior products;Unquoted-Stories of Price Manipulation: E.Com Infotech;Steady Performance). Despite this, purely quantitative methods of beating the market have been in the vogue of late. It requires significantly less effort in selecting stocks and more effort in creating a formula which can be automated. As the investment landscape has changed rapidly, the need to pick stocks quicker than the rest and make quick money, often over the short-term rather than long-term, becomes important. In the old days, all one needed was an annual report. Now, a computer is required to run quantitative calculations. However, sometimes, like stock picking, if quantitative method can be applied correctly by the investor, it can work.
In this case, Morgan Stanley has used a quantitative tool using correlation to determine which sectors are worthwhile. Sometimes, investors like to go ‘contrarian’ or against the crowd. For instance, if the crowd is buying, then some would like to sell and vice versa. It is more of a psychological indicator rather than a fundamental one. This trait is more developed through experience rather than algorithms and mathematical formulae. Morgan Stanley Research has come up with a quantitative ‘contrarian’ indicator to time stocks, based on correlation. When correlation between the “broad market” returns and the Sensex returns are high, it is time to do stock picking and vice versa. At the moment, the correlations are low, and therefore ripe for going macro. In other words, the Sensex, which contains only 30 stocks, and the broader market, which consists of hundreds of stocks, exhibit almost the same returns, and therefore there is not much of a case for going into the nitty gritty details of stock picking which requires hard work.
Further, the report said, “When the correlations are high and rising (as has been the case for most 2011 and 2012), it means the macro has wielded undue influence on stocks. Our strategy is to do the opposite, because we argue that at any point in time there are always individual factors driving stock returns. The opposite holds true as well. Hence, when correlations are low, macro influence is absent, and the market is overly focused on idiosyncratic stock factors—to us, this is the time to get macro.”
However, the levels aren’t extreme enough to be a total contrarian (i.e. go full macro or sector-wide investing rather than individual stock picking). It is somewhere between stock picking territory and macro-investing territory. If it is somewhere ‘between’ stock-picking territory and macro-investing territory, then surely there are opportunities to indulge in stock picking.
All this observations might stump most investors who are into stock picking because there’s always an opportunity lurking everywhere, whether it is to go long or short a particular stock. Having said this, it still believes that stock picking is ripe in some sectors but stopped shy of mentioning the specific stocks to invest. It believes financials, utilities, industrials and materials will offer bottoms-up stock picking opportunities. The report said, “Correlations seem high in utilities, financials, industrials and materials. These sectors are more amenable to stock selection. We are neutral in these sectors, except for materials.”