We are somewhere between the macro and micro trade but no longer firmly in stock-picking territory
Since February 2011, we have been advocating a stock-picking approach to the market. Our strategy between macro (big sector positions) and micro (stock focus) is determined by our correlation work.
The average of the correlation of stock returns in the broad market with the Sensex returns tells us whether the market is being influenced by macro or whether it is all about idiosyncrasy. 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. Correlations appear to be mean reverting, and, therefore, correlation extremes represent a chance to be contrarian.
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.
Thus, we have started to widen our sector positions. Incrementally, we are adding to cyclicals and trimming defensives. Valuation (P/B) dispersions are could also be peaking, and mean reversion is possible – implying narrower valuation gaps between cyclicals and defensives. Dispersal in ROE is not rising to support more diffusion in P/B.
At the sector level, stock-picking opportunities persist in utilities, financials, industrials and materials (we are neutral on all except materials), whereas other sectors are demanding a macro approach. Accordingly, we are overweight consumer discretionary, energy and technology, and underweight staples, healthcare and telecoms.