- Forecasts for 2020 abound right now, 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 the relative-return dispersion is low in many equity markets around the world. And it’s been low for a long time, which has engendered increasing overconfidence. Many active managers have been required to take larger active bets to maintain their active risk objectives. When dispersion reverts to typical levels, it is likely to happen faster than they can trim their risk.
- At the same time, correlations of stock returns have soared. This combination of low dispersion and high correlations points to a “groupthink,” causing an unjustified sense of security and leaving fewer places to hide when volatility moves higher.
- The potential consequences for a changing market regime require your full attention on equities right now – irrespective of your policy allocation. We believe a defensive mindset is essential, starting with a thorough review of your managers’ active bets and the inclusion of strategies offering complementary returns and comprehensive risk controls.
No prognostications here
Generally, the ability of active managers to outperform the market and produce reliable alpha over the long term is a function of their skill at managing risk, not just evaluating the sources of active exposure, but also whether these risks are compensated. The coming years will be no different. Which tail risks are most likely to materialize? And, once they materialize, which ones are likely to be the most disruptive? We hope to shed light on those questions in this paper without directionally forecasting.