Since the end of 2008, central banks have been conducting the largest economic experiment in history. By expanding their balance sheets and slashing interest rates, monetary policymakers have dramatically altered return patterns across asset classes. Bond prices have been chased to record highs, commodities have experienced white-knuckle volatility, while equities have plunged and then mostly recovered — for now. The uptick in volatility since mid-2015 — the Chicago Board Options Exchange Volatility index has had a daily average of 19% over the past six months against 16% in the preceding six — has made the stock picker's art more difficult than ever before.
One of the ways in which equity markets have been affected is that correlations between stocks have increased. Quantitative easing has been a tide that has lifted all ships, and so equities have risen or fallen indiscriminately based on the inclinations of Mario Draghi, president of the European Central Bank. But high correlation need not mean low dispersion. If the former is defined as the degree to which the price movements of two assets are related, then the latter is the absolute difference in performance across a relevant time period.
We believe the unusual market dynamics seen recently are likely to continue. Specifically, we expect to see repeats of the volatility of late 2015 and early 2016. Dispersion tends to increase as volatility rises. Consider figure 1 as an example. The graph shows a close relationship between the VIX and 3-month dispersion across European stocks.
Equity market-neutral strategies seek to capitalize on dispersion by monetizing the differential between outperformers and laggards in a given universe. If the aforementioned interaction between volatility and dispersion holds, we believe we could be headed toward a conducive environment for equity market-neutral investment. To take a sector example, the one-month rolling dispersion for financials between the 30th and 70th centiles has hovered persistently around the 5% mark since the global financial crisis, irrespective of region. This might surprise some, as intuition would suggest that trends such as capital requirements and other regulation would have affected the industry in a more uniform fashion. These levels of dispersion imply the potential for a skilled stock picker to harness alpha through long and short positioning.