Charts of the Day - Why top-down Macro remains more important than ever

"Facts are stubborn things; and whatever may be our wishes, our inclinations, or the dictates of our passions, they cannot alter the state of facts and evidence." - John Adams, American president

While we recently indicated our concerns relating to the relationship between rising positive correlations thanks to central banks' markets meddling and rising +/-4 standard deviations moves or more in asset classes in our August short conversation "Charts of the Day - Positive correlations and large Standard Deviation moves", we believe that top-down Macro remains more important than ever thanks to these rising correlations.

This can be ascertained from Bank of America Merrill Lynch's "Global Focus Point note from the 7th of September entitled "3 million data points soared":

"Correlations skyrocketed in August
In August, global stock-to-stock correlations jumped to the highest level in four years. Macro concerns ranging from fear of the Fed raising rates, China slowdown, risk of Greece contagion, and falling GDP forecasts have marred equity market returns recently. Stock-to-stock correlations are signaling that stocks are performing similarly to each other. Factoring in macro issues becomes much more important than pure fundamentals during phases of rising correlations.

3 million data points
Stock-to-stock (or pair-wise) correlation is correlation between daily price returns of each stock in the MSCI ACWI index to the daily price returns of every other stock (i.e., 3 million calculations each month). Last month correlations jumped above long-term averages in all major regions and sectors of the world. Correlations are highest in Japan, followed by Europe and the US. Previous jumps in correlations have coincided with falls in global equity markets, on average.

Signals from the Global Wave critical
Rising stock-to-stock correlation coupled with weakening Tactical Indicators suggests that macro is more important than ever. The Global Wave, our macro indicator, continues to fall after signaling a peak in the global economic cycle in January. Investors should closely monitor the signals from the Global Wave for clarity on the macro environment.

What to buy?History suggests defensive styles and sectors tend to do well when the Global Wave is falling. This suggests overweighting the Bunkers which are based on styles for a downturn including earnings stability, low beta, low estimate dispersion and high dividends.

The best performing sectors when the Global Wave is falling tend to be Health Care and Consumer Staples, and the worst include Materials and Industrials." - source Bank of America Merrill Lynch

Furthermore a low beta strategy of "overweighting sectors such as "Consumer Staples" can be seen as an embedded free "partial crash" put option.

We already approached this very subject in our 3rd of April 2013 conversation "Equities, playing defense - Consumer Staples, an embedded free "partial crash" put option":

"The value of the put option offered by the Consumer Staples sector protects investors from monthly declines of 5% or more i.e. you can generate market performance and be insulated to a degree from major market shocks." - source Société Générale

As per our previous April 2013 note:
Consumer Staples are mostly a defensive play that can outperform during phases of "Risk-Off" which we have been experiencing on numerous occasions since the financial crisis of 2008:

"The low-volatility index did best in times when stocks fell, such as 2000 to 2002, and in 2008, according to S&P data. In 2008 the low-volatility index fell 21 percent compared with 37 percent for the S&P 500." - source Bloomberg.

As a reminder, another way in protecting a portfolio is investing on ETFs such as the PowerShares S&P Low Volatility Portfolio for protection from stock-market swings because Consumer Staples account for around 22%.

Some inconvenient facts: Low volatility stocks have provided the best long-term returns, one of the greatest anomalies in finance.

 "Defense is a definite part of the game, and a great part of defense is learning to play it without fouling." - John Wooden, American coach

Stay tuned!