2012 has of course yet been another year dominated by Macro, with wild swings in sentiment caused by the European debt crisis and the threat of Middle Eastern conflict. The “risk-on” vs. “risk-off” attitude of the market has been driving driving most hardened stockpickers nuts. In this context, Goldman Sachs published a very interesting piece back in June this year entitled "Bridging macro to micro: GS top-down stock selection" which looked at the interplay between macro and micro factors in relation to stock-picking. It's focused on Asia but a lot of the thinking is of general interest.
Goldman's thoughtful approach is essentially systematising the kind of "trouble in Iran - rising oil prices should drive this stock" anecdotal macro handwaving that you so often see from analysts and market pundits. The aim was to develop a top-down stock picking framework bridging from the macro to the micro by building upon "macro factor mapping, micro-specific comparisons, and business-cycle-based investing".
Bottom-up screening isn't everything...
Unsurprisingly, Goldman Sachs' work found that macro analysis is important to equity returns, even to bottom-up-oriented stock pickers, with factors such as global growth, domestic growth and financial conditions being important return drivers for c. 60% of the market cap of Asian equities. Of course, the problem with macro data is there's so much of it. However, while investors can be overwhelmed by noise, Goldman found certain macro variables to be much more important - said another way, many macroeconomic variables are highly correlated. They found that stock pickers can simplify macro monitoring by focusing on six factors (discussed below) which explain a significant part of an individual stock’s return variations.
Essentially their top-down stock-picking process involves three steps:
- What phase of the business cycle are we in and, for that phase, how are the key macro-economic factors positioned?
- In light of this macro environment, which stocks are expected to do best based on stock specific regressions for each macro factor?
- Having determined relative macro rankings across the equity market, how are micro factors (i.e. valuation, fundamentals and technical indicators) likely to impact expected returns?
The Business Cycle & Macro Factors
As explained in more detail in their paper "Global Economics Paper No: 214, Acceleration Matters: Asset Returns and the Business Cycle", using their proprietary "Global Leading Indicator" (GLI), the GS team define…