Uncertainty abounds with this year’s increased equity market volatility. But while we’ve seen increased market volatility, we’ve also seen an increase in relative stock price volatility. In other words, we’ve seen an increase in stock prices moving differently from other stocks and the overall market. This is called dispersion.
The increase in dispersion is important for two reasons. First, it’s an ever-present alpha source for us and available in both up and down markets. And second — important to all of our readers – dispersion has been extremely low for some time now which can suggest a high level of equity market stress. It’s important for investors of all stripes to understand dispersion and its implications on investing.
Understanding Return Dispersion
Dispersion measures whether stocks’ returns relative to their benchmark are converging (low dispersion) or diverging (high dispersion). As dispersion increases, underlying stock or portfolio returns begin to diverge from the overall market, offering opportunities for active management.
This can often be explained by the fact that active returns are a function of cross-sectional volatility and active share. For example, if the cross-sectional volatility of the equity market is zero, meaning that all stocks perform exactly the same, then all active portfolio returns equal the return of the benchmark regardless of a manager’s active bets. However, substantially high OR low dispersion is generally associated with strain on the market. Right now, dispersion is abnormally low, which is suggestive of groupthink among equity market participants.
Groupthink can drive many decisions – some good, some bad. But when it drives the market it’s a leading indicator of a market shock. In the first half of 2018, we observed a slight uptick in the dispersion of returns measure since the end of last year, confirming a slight increase in cross-sectional volatility. Despite the uptick, stocks’ relative volatility in the U.S. remains very low by historical standards, reflecting a market that continues to be driven by sentiment and macroeconomic dynamics rather than stocks’ underlying fundamentals. And while we aren’t seeing the historic lows that we saw in 2014, we are lingering in an area of abnormally low dispersion.
Historical Dispersion Levels
As shown in Figure 1, dispersion was abnormally high during the build-up and aftermath of the tech bubble. It was abnormally low during the 2005-2007 period – similar to where we are today.
Dispersion is Not Enough
Dispersion of returns is one of five metrics we believe are reliable indicators of equity market stress and a component of the new Intech Equity Market Stress Monitor™. This new risk profile of the equity market – a collection of five reliable indicators of market strain – help identify different risk regimes and associated tail-risk.
Learn about the other indicators of strain in the market and how to use the monitor in your everyday work by downloading the eBook and quarterly report below. View the latest Intech Equity Market Stress Monitor® quarterly report that offers our analysis of the data.
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