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.