Top Stories

Idiosyncratic Risk On The Rise, Morgan Stanley Quants Warn

Idiosyncratic risk, volatility not explained by the larger beta market environment, is on the rise. Median 63-day rolling risk has not just hit new highs since the financial crisis, the Morgan Stanleyreport dated December 12 noted. But the idiosyncratic risk has risen to highs not seen since October 2000.

Get The Full Warren Buffett Series in PDF

Get the entire 10-part series on Warren Buffett in PDF. Save it to your desktop, read it on your tablet, or email to your colleagues

Idiosyncratic Risk Morgan Stanley Report

Idiosyncratic risk up significantly as overall market volatility hits all-time lows, Morgan Stanley Report observes

Stock specific risk is “up sharply” on a 63-day as well as 252-day basis, Brian Hayes and his quantitative equity research team at Morgan Stanley observed, noting that such risk is “positive for subsequent alpha generation.”

The rise in individual stock risk comes as the overall stock market is experiencing historically low volatility, illustrating how noncorrelated volatility factors can mitigate each other. The CBOE VIX index was trading at 9.28 today, almost half its longer term average.

In small cap stocks, valuation factors, after having difficulty throughout 2017, have been staging a rebound, a Bank of America Merrill Lynch report recently noted. When looking at the entire stock market, including large capitalization stocks, the picture is slightly different.

While the performance of equity factors can differ from study to study to study based on how they are defined, the Morgan Stanley report noted that “neither growth nor value stocks outperformed in November,” which was juxtaposed to the BAML findings for small-cap stocks.

Idiosyncratic Risk

Idiosyncratic risk in reverse: growth stocks performing well as big tech names lead the way

Overall in Morgan Stanley’s analysis, growth stocks still lead the factor race when considering the wider market, up 8.9% on a risk-adjusted basis year over year. Those stocks where valuation factors such as price to earnings or price to book are not the key performance driver are dominated by the technology sector. Of the top ten growth stocks in Morgan Stanley’s analysis, six are technology related, with Alphabet, Amazon, Facebook making up the top three respectively.

When looking at quality – a factor that doesn’t consider the price of the stock, but rather by items such as profitability and earnings growth – high quality stocks outperformed “junk equity” by 2.4% in November, the Morgan Stanley report noted. But the stocks that were the big winners in November where “moderate quality” stocks.

“Strength of moderate quality suggests that risk aversion is not the driver of recent higher quality outperformance,” the Morgan Stanley report observed, even though the 12-month cumulative quality-junk spread fell to 6.9% in Morgan Stanley’s reading, one of the lowest levels in the last two years.

Low beta stocks, those with higher idiosyncratic risk, underperformed high beta by 1.1% in November. That happened as the market generally notched gains leading into a US Federal Reserve hiking cycle.

In November, defensive stocks beat cyclicals by 2% on a risk adjusted basis, which reversed a three-month trend of cyclical outperformance. The three-month cyclical outperformance was a mean reversion in an overall trend of defensive outperformance, as the last 12 months defensives were ahead of cyclicals by 5.5% with certain financials lagging this indicator of late, the report noted.

“In November, investors appeared to focus on return of capital,” with a reduction in share count being the best factor, potentially influenced by forthcoming tax reform bill being contemplated in Washington DC. In this environment, total yield and dividend yield also performed above average.

High cash levels were still in favor as “factor performance was highly nuanced,” with low debt to EBITDA working well. But this is contrasted to debt to equity and debt to market cap underperforming.

Looking ahead, the Morgan Stanley model suggests overweighting equity market, size and accrual factors. “Momentum has a low weight for December, reflecting its high recent volatility,” the report observed.

Idiosyncratic Risk