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Forecasts for 2020 are easy to come by, but market efficiency makes these prognostications difficult to exploit in a directional sense. Instead, by examining the relative behavior of stocks, we attempt to offer an integrated view of equity-market opportunities and risks upon which you can act.

Today, we observe that relative return dispersion is historically low in many equity markets around the world. Return dispersion is also known as cross-sectional volatility. It measures whether stocks’ returns are converging (low dispersion) or diverging (high dispersion) relative to their benchmark. Low dispersion tends to be indicative of excessive groupthink, so it’s usually an indicator of underlying market strain.

In Figure 1, we illustrate the percentile rank in dispersion of returns across various global indexes and include rankings from a year ago for comparison. In general, the return dispersion for major indexes is well below historical medians and is in the bottom quintile for a majority of them.

 

Dispersion of Return Ranks Across Equity Indexes are Low_fig1


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Consequence of Convergence

Lower dispersion typically means that overall market sentiment, rather than individual company results, is driving stocks’ returns. It indicates that, despite the euphoria across a broad market segment, the largest and most sophisticated investors are reluctant to make large trades and build large positions; they’re anxious and appear to “wait for the other shoe to drop.” The higher their anxiety, the more magnified the eventual market’s response to either positive or negative news.

 

Here’s how it potentially unfolds: unexpected events, which investors might normally take in stride, increasingly cause some investors to take positions away from consensus in an attempt to anticipate market direction. Investors committed to consensus may wait, but their anxiety grows like in a game of musical chairs. As consensus thins, it releases pent-up, unrealized drift between stocks, which dramatically magnifies risk exposures faster than most investors can manage them.

It’s telling that the last time we saw such low levels of return dispersion was between 2005 and 2007 (Figure 2). In such a strained regime, it is important for investors to examine managers’ ability to evaluate risk and dynamically adapt their portfolios to rapidly changing market conditions.

 

Dispersion of Return Rank Over Time_fig2

 

But Wait, There's More

Dispersion describes the absolute magnitude of relative stock price movements, while correlation measures the relative alignment between their movements. Today, while we’re observing persistently low dispersion across global equity markets, we’re also seeing a dramatic increase in correlations across these same markets (Figure 3). In other words, not only are the stocks’ relative returns converging, but they are also moving in tandem!

 

Correlation of Returns Ranks Across Equity Indexes Have Increased_fig3


Historically, such high correlation, especially when combined with low dispersion, has been useful in identifying high likelihood for black swans, like the periods in the mid-1990s and the beginning of 2007, which preceded major market disruptions.

The market levels of dispersion and correlations are powerful leading indicators: they belong to a class of equity market metrics that are reliably stable over the long term. These metrics comprise the Intech Equity Market Stress Monitor®. When these measures depart from their typical values, they offer a sign of strain in the market. The monitor allows investors to examine equity market stability over time.

Of course, these metrics do not represent a guarantee of market dislocation, especially in the near term. But just as Wile E. Coyote won’t start falling until he’s realized he’s stepped over the cliff’s edge, the market can pursue bubble dynamics for a while. And the longer and further dispersion and correlations deviate from equilibrium, the more potential energy is stored in the market, and the more painful the eventual snap will be.

What Does this Mean for Your Portfolio?

The potential risks due to the high levels of strain indicated by the low return dispersion and high correlations require your full attention on equities – which, even in normal market conditions, constitutes the largest source of risk in a typical portfolio. What questions should you be asking about your equity allocation? Learn more by downloading our paper, “Welcome to 2020: This is Tail Risk We’ve Seen Before.”

Welcome to 2020: This is Tail Risk We’ve Seen Before  Examine the current market environment and the potential risks ahead. Download Now

 

The information expressed herein is subject to change based on market and other conditions. The views presented are for general informational purposes only and are not intended as investment advice, as an offer or solicitation of an offer to sell or buy, or as an endorsement, recommendation, or sponsorship of any company, security, advisory service, or fund nor do they purport to address the financial objectives or specific investment needs of any individual reader, investor, or organization. This information should not be used as the sole basis for investment decisions. All content is presented by the date(s) published or indicated only, and may be superseded by subsequent market events or other reasons. Past performance is no guarantee of future results. Investing involves risk, including possible loss of principal and fluctuation of value.