The U.S. equity market’s dispersion rose substantially in July, ending the month at 7.3%, well above June 30’s 4.5%. Dispersion for the S&P MidCap 400® and S&P SmallCap 600® likewise rose in July, and the component correlation of all three indices declined. This is not surprising in a month dominated by individual earnings announcements. Lower correlation means there’s less tendency for stocks to move together, and higher dispersion means that the gap between the winners and the losers grows — more or less what we’d expect when company, rather than macroeconomic, news is most important.
We’ve long argued that the market’s low dispersion in 2014 was a major contributor to the failure of most active managers to outperform their index benchmarks. So if dispersion remains high, other things equal, active stock pickers might benefit. But there are at least three cautions to offer before concluding that the long-sought “stock-picker’s market” has finally arrived.
First, dispersion might not stay high. July’s upward move is impressive, to be sure, but in January 2015, S&P 500® dispersion rose from 4.2% to 6.7%, a move almost as large as July’s. Dispersion fell in the next two months, so that by the end of March, it was back to its year-end level. One month, in other words, does not a high dispersion regime make.
Second, the percentage of active managers who outperform their benchmarks does not depend on the level of dispersion. Dispersion is a pre-cost measure, so if dispersion rises relative to its 2014 level, more managers may be able to earn enough incremental return to cover their trading and research costs and generate positive alpha for their clients. But this is a marginal effect. As our SPIVA research has consistently demonstrated, most active managers underperform most of the time. If dispersion rises, successful stock pickers will earn more, and unsuccessful stock pickers will lose more.
Finally, rising dispersion will have predictable effects on the performance of some factor indices. For example, if winners keep winning and losers keep losing, that’s a recipe for increased dispersion. In such an environment, momentum indices (which buy winners and shun losers) will tend to do well, and equal weight indices (which do the opposite) will tend to underperform. (In July, in fact, the S&P 500 Momentum Index outperformed its equal weight counterpart.) Through July 31, the cap-weighted S&P 500 outperformed equal weight (3.35% vs. 1.69%). Rising dispersion might cause that gap to widen.
An equal weight index measures the return of the average index component. When equal weight is outperforming cap weight (as it typically does), stock picking is relatively easy — in fact a randomly-chosen portfolio should outperform the cap-weighted index. When cap weight outperforms, stock picking is much harder. (Some active managers recoil in horror at the memory of the late 1990s, when the cap-weighted S&P 500 outperformed equal weight for six consecutive years.) If cap weight continues to outperform equal weight, stock selection will continue to be challenged, regardless of dispersion’s level.