While analysts and pundits have offered a veritable cornucopia of reasons for the market's sharp swoon in the fourth quarter, and December in particular, ranging from Fed policy error, to peak earnings, rising wages, economic slowdown, ongoing trade war, political chaos, higher rates, lower rates, China, algos and so much more, to Bank of America the answer is simple and can be summarized in one word. In a note released today by the bank's chief equity strategist Savita Subramanian, she writes that what explained returns most during the fourth quarter sell-off was... "Macro."
With macro headlines dominating – labor inflation, trade tensions, the Fed, quantitative tightening, oil, China – the bank has devoted a section of its Year Ahead to macro implications for sectors from some 40 macro factors as today "macro is more important than ever, where macro betas – or stock sensitivities to oil, inflation, credit spreads and housing permits – have risen to all-time highs."
Given their importance, Bank of America has followed in Goldman's recent footsteps, and has started tracking macro sensitivities at a stock level to identify critical exogenous drivers for stocks "in order to help identify which macro factors matter for an individual stock, prioritize their relevance and show how stocks with fewer macro sensitivities tend to perform better in terms of lower realized volatility."
In the table below from the bank's 2019 Year Ahead report, the bank has listed a number of macro risk factors that can move the market one way or the other, with Subramanian noting that in her view, the biggest risks are trade tensions with China and rising interest rates, while upside risks to the US dollar and cost inflation outpacing companies’ pricing power can also put pressure on margins. Additionally, oil is also on watch, having fallen into bear market territory in Nov 2018.
In a more granular breakdown of how the assorted factors impact various market sectors (in terms of beta), Subramanian writes that while most sectors are statistically significant across majority of Macro Factors, it is the VIX, credit spreads, CRB Index, USD, and GDP that have the most impact across the sectors
Shown another way, the VIX, credit spreads, and the CRB Commodity Index have the highest proportion of BofAML US-covered stocks with statistically significant macro betas (Chart 2). These top macro betas typically do not vary a lot from year to year, but remain consistently high, with ~90% of the BofAML US-covered stocks having statistically significant betas.
As the above chart shows, not surprisingly the most important macro factor for stocks is the VIX. And, in an ominous warning from Subramanian who uses one of our favorite charts, the one showing the historical correlation between the VIX and the 2s-10s spread, warns that the VIX is "likely to double by 2021", which is definitely not good news for stocks.
Here's her explanation:
As shown in the Chart above, the VIX is the most important macro factor for US stocks: in aggregate, over 95% of BofAML US-covered stocks have statistically significant relationships with moves in VIX.
This is a problem because as we have discussed in the past, and as BofA reminds us again today, "a flattening in the yield curve over the last three cycles has preceded rising volatility by about three years, as shown in Chart 1." As a result, BofA's chief equity strategist "expects a more volatile backdrop for US stocks in the coming years" and believes that as a result, "it will be important to own stocks less sensitive to this and other macro factors."
As noted above, some stocks tend to move more with macro factors (i.e. high systematic risk) while others move less (i.e. more idiosyncratic). And after conducting a backtest analysis, the results from the stock screen and a backtest of its performance over time show that idiosyncratic stocks have outperformed systematic stocks, primarily due to lower annualized volatility of the former (13.8% vs. 20.6%), with slightly better annual returns of 13.2% vs. 12.5%. This, to BofA, is attributed to the inherent diversification that can be achieved by constructing a portfolio less correlated with macro factors. Additionally, the outperformance of idiosyncratic stocks in the bank's backtest did increase moderately over time, getting a boost during the 2008 financial crisis. This is related to the charts to come, as we note that equity fundamentals have mattered more during crisis events.
Putting all of this together while urging clients to avoid companies that are overly exposed to macro/systematic factors - as a result of the upcoming surge higher in the VIX if nothing else - BofA finally provides a list of the the 50 lest expensive stocks with high FCF/EV multiples, that are driven by idiosyncratic factors instead of systemic ones. In other words, if one wishes to hedge against a possible coming crash in the stock market while staying invested in the market, they should do it using a basket of these 50 stocks.
Finally, this is how BofA explains its trade reco for achieving alpha nirvana (i.e. avoiding macro exposure): "stick with stocks that act like stocks." To wit:
Some stocks tend to move more with macro factors (or have more systematic risk), while others move less with macro variables (or are more idiosyncratic) and are more sensitive to company-specifics like brand, pipeline etc. We identify the most idiosyncratic and most macro-sensitive stocks based on sensitivities to the 40 macro factors analyzed, controlling for co-movement of macro variables.
The bottom line from all of the above: "idiosyncratic stocks have tended to outperform macro-sensitive stocks, especially during crises, primarily due to lower volatility but also due to slightly superior annualized returns. Moreover, diversification benefits tend to be greater from constructing portfolios of stocks less correlated with macro factors. And inexpensive idiosyncratic stocks have outperformed inexpensive macro stocks on a variety of valuation metrics."
Of course, the assumption is that investors who are worried about a coming "crisis" will prefer to stay investors in equities, instead of pulling their cash and allocating it to either paper money, or a safe haven such as gold or Treasurys. To find out which of these various options investors will pick, tune in shortly after the next crisis begins to find out if BofA's idiocyncratic basket has outperformed i) the systemic basked and ii) market.