Morgan Stanley argues that the key forces driving stocks will make a major transition from "macro" forces in 2018 to individual drivers in 2019. As the market becomes more volatile, Morgan Stanley analysts argue that stocks in sectors including consumer discretionary, communications services, information technology and healthcare have the most upside. Morgan Stanley’s top picks include WellCare Health Plans (WCG), Align Technology (ALGN), Nektar Therapeutics (NKTR), Twitter Inc. (TWTR), Netflix Inc. (NFLX), Ulta Beauty Inc. (ULTA), Macy's Inc. (M) and L Brands Inc. (LB), as outlined in the investment firm’s recent report titled, “U.S. Macroscope: Shifting from beta to alpha.” 

Thanks to a less-hawkish Fed and forecasts for a stabilizing U.S. economy, Morgan Stanley expects S&P 500 returns to ease in the near-term. Meanwhile, analysts expect returns to “become more more micro driven and recommend investors focus on relative value and idiosyncratic (Alpha) opportunities," wrote Morgan Stanley, recommending that investors focus on "alpha" rather than "beta" in the near-term. "Stock picking opportunities are most plentiful within consumer discretionary, communications services and health care,” added Morgan Stanley.

Market Largely Priced in Macro Factors

Morgan Stanley listed 50 S&P 500 stocks with the highest idiosyncratic risk, either positive or negative, based on the firm’s dispersion score framework. While the market been largely driven by macro factors in the recent months, such as market, value, size and sector, analyst expect micro, or residual factors, to explain an increasing share of S&P 500 returns. For example, average 3-month stock correlations spiked from near a record low in October to the 94th percentile today, marking the fourth largest surge on record. Further, the ratio of single stock to index volatility recently fell below its long-term average, contrasting to the post-election environment. Morgan Stanley expects these trends to reverse as “alpha” plays a greater role in stock returns.

While volatility has risen, a surge in correlations has resulted in narrow return dispersion, measured as the cross-sectional standard deviation of S&P 500 constituent returns, wrote Morgan Stanley. Moving forward, analysts recommend investors focus on alpha rather than beta in the near-term, given the market has already priced in much of the macro backdrop.

Company-Specific Factors to Drive Returns

Morgan Stanley’s forecast for the S&P 500 to 2,750 by mid-year implies a near flat run from current levels. In light of this modest outlook, analyst recommend investors focus on stocks with high idiosyncratic risk, as represented by the firm’s dispersion score framework, calculated using both the proportion of returns drive by micro (company-specific) factors, and the firm’s forecast of the volatility, or “risk” associated with the proportion of return attributable to micro factors. It’s important to note that a high dispersion score does not suggest only positive returns, but those that deviate most from market returns in either direction.

Examples of stocks with high dispersion and also strong 2019 earnings and sales, include Advanced Micro Devices Inc. (AMD), with a dispersion score of 18.2 and 2019 EPS growth of 37%, as well as healthcare play Incyte Corp. (INCY), with a dispersion score of 8.7% and 2019 EPS growth at 92%. These factors imply strong upside potential vs downside for these stocks.

Two stocks out of Morgan Stanley’s list with high dispersion scores but weak2019 earnings and sales, implying strong downside, include materials company Freeport-McMoRan (FCX), with a dispersion score at 5.7 and expected 2019 EPS growth at negative 69%, as well as Nektar Therapeutics, with a dispersion score of 13.6 and 2019 EPS growth at negative 152%.

Looking Ahead

Morgan Stanley stresses that while stock pickers can get huge upside by buying these stocks, they also have equal downside. The bank also emphasizes that investors should look at these plays as short-term bets. For that reason, perhaps only the most experienced investor is suited play this micro game due to the fact that these high-dispersion stocks could move dramatically up, or down, on the slightest good or bad news.

Meanwhile, short-term macro-uncertainty persists, such as developments with U.S.-China trade tensions, which could represent a near-term catalyst for a broad-based move in U.S. equities. "Any meaningful surprises (positive or negative) in global growth data would likely lift the importance of market beta for stock returns,” added Morgan Stanley.