While the recent rally in equity indexes is encouraging for institutional investors, the risk-on/risk-off behavior that characterized market performance during 2011 is unlikely to be quickly forgotten. During this time, it appeared that the market was no longer willing to differentiate between specific companies, preferring to trade stocks as if their underlying fundamentals were almost identical.
The resulting correlations between stocks have, therefore, remained consistently elevated, and not just in 2011. That trend has persisted since 2007 and across all global stock markets. Throughout that period we have seen the increasingly dominant role of macro-driven views — or concerns. This has been driven by the rise of global macro hedge funds and absolute-return products and exacerbated by the growth of exchange-traded funds.
While some semblance of normality might be returning to traditional long-only equity strategies, the underlying structural reasons for elevated correlations in equity markets remain in place. In this environment, it is important to examine the drivers of recent volatility and consider the implications for fundamental stock pickers.
Even with these shifts in recent years, the companies and businesses behind the stock market continue to develop and behave in more conventional ways. We believe that, while short-term swings in macro sentiment might affect stock prices, it is inevitable the underlying realities of corporate business performance will eventually be reflected through financial results or company actions. Ultimately, it is these factors that underpin share price performance.
We believe the unprecedented volatility during 2011 actually serves to strengthen the case for a fundamental stock-selection approach. Indeed, we would argue that in an environment where a greater proportion of market participants are overlooking stock specifics in favor of macro drivers, returns available to stock pickers should be enhanced.
The ”pair-wise” correlation is a useful measure that demonstrates the extent to which stocks move together over a period of time. Chart 1 shows that between 1990-2007, U.S. stocks were relatively uncorrelated, with correlation ranging between 5% and 45%. Since 2007, however, stock correlations have remained consistently elevated, occasionally spiking as high as 71% during periods in 2011. A similar trend has emerged across other global stock markets.
The evidence suggests that these elevated correlations can be traced to a profound structural change in how investors trade stocks in the market. A greater than ever “weight of money” is trading stocks based not on underlying company fundamentals but driven by macro considerations — either to express a macro view or to hedge macro risk.
One reason for this shifting investor behavior is the growth of ETFs, which are regularly used to reposition portfolios or take regional or sector exposures based on macro views. These funds are estimated to have witnessed more than $400 billion in fund inflows globally since 2007. This has been offset by more than $500 billion outflows from long-only equity funds in this period. In the U.S., the growth of ETFs has been particularly pronounced, with these funds now estimated to account for up to 30% of daily trading volumes in some S&P 500 stocks.
Another important trend in recent years has been the growth in global macro investing — driven both by the development of global macro hedge funds and absolute-return products. According to Hedge Fund Research, global macro hedge fund strategies have seen inflows of more than $150 billion since 2007, resulting in a 50% increase in their assets under management. Equity hedge fund assets under management, meanwhile, had seen a net reduction over that period. Absolute-return products, which also often take a macro approach to investing, have seen strong inflows as well. These funds' flows, as in the case with ETFs, contribute to the weight of money that trades stocks based on macro views.
Finally, we have witnessed a significant rise in the number of stock market participants who are active users of hedging techniques, especially during periods of elevated macroeconomic concerns. Even if hedging is undertaken through derivatives, the counterparty to these derivatives trades is likely to look to offset the risk by going short underlying stock indexes.
Another underlying shift in trading behavior might be a result of what we call “closet macro investing” — when investors who are normally bottom-up stock pickers de-emphasize fundamentals and join macro investors in trying to anticipate the next turn in macro news flow or sentiment. While difficult to quantify, we see some evidence of this process occurring over the past few years.
Corporate fundamentals are still a key driver
All of these factors contribute to what we believe is the greater than ever weight of money that trades global stock markets on a macro basis. In 2011, this resulted in elevated stock correlations and effectively meant the market was paying less attention to the stock-specific factors in share prices. Our view, however, is that the underlying realities of corporate business performance will still be reflected through financial results or company actions. Those factors will underpin share price performance.
Nevertheless, the elevated macro volatility had a predictable impact on sector performance during 2011. Defensive sectors, like health care and consumer staples, performed better, posting an overall positive return, while cyclical sectors, such as materials or industrials, were weak. However, even in this macro-dominated market environment, stock selection ultimately mattered most. Chart 2 shows the average return of the five best performing stocks in each MSCI World sector compared to the performance of the sectors themselves. Here, the performance of specific stocks dwarfs the performance of the sectors — and even in cyclical sectors, such as industrials or consumer discretionary, we have seen very strong performance from individual stocks.
On a stock-specific level the trend is even more pronounced. Take, for example, the global payment network firm Mastercard. The nature of its business places it at the intersection of the financial and technology sectors — neither of which is particularly defensive. Even so, Mastercard share price delivered 66.7% return in 2011 on an absolute basis and a 71.7% relative return over the MSCI World index. There were a number of company-specific factors that drove that performance. The stock started the year at a depressed valuation level, reflecting investor concerns about the cyclical nature of the business and increased regulatory scrutiny. However, during the year the company demonstrated that its underlying profitability remained healthy, its long-term growth prospects attractive and the regulatory threat limited. These company-specific factors drove the share price performance, regardless of the macro and sector rotation pressures.
Another such example is U.K.-listed engineering firm Weir Group. The company belongs to the industrial sector, which performed poorly as the market shunned cyclical stocks in 2011. However, Weir's stock-specific factors more than offset these sector headwinds. The company continued to benefit from growth in both mining and shale oil and gas capital expenditure during 2011. As a result, Weir delivered a string of strong results and market updates that drove shares up 15.2% on an absolute basis and 20.2% relative to the MSCI World.
Investors' ability to identify and analyze such company-specific opportunities remains undiminished. Investment firms capable of committing sufficient analytical resources in the search for stock-specific investment ideas should continue to profit from this approach, with the global equity sector still the widest opportunity set for bottom-up equity investors. The more there are market participants that take a macro-driven approach and overlook stock specifics the more returns should be enhanced for the stock pickers. While there might be periods of volatility, when stock specifics do not appear to matter, stocks inevitably will perform strongly when companies deliver on the underlying investment case. And during the periods of volatility stock pickers can build positions in stocks they like for company-specific reasons at prices less reflective of their underlying fundamentals.
Mikhail Zverev is a fund manager, global equity unconstrained, for Standard Life Investments.