- As the S&P 500 reaches new highs, volatility has hit new lows, according to Goldman Sachs analysts.
- Low volatility can create low return dispersion, which brings a more challenging stock-picking environment.
- We list the analysts 25 stock picks most likely to generate alpha returns and crush the market.
- See more stories on Insider’s business page.
Volatility has declined to its lowest levels since January creating a more challenging environment for stock pickers, according to Goldman Sachs analysts.
In a new research report released on April 16, the analysts highlight volatility has fallen at the same time as the S&P 500 reaches new highs.
Last week, the S&P 500 closed at a record high of 4,185.47, while the index is up 11% this year.
At the same time, the S&P 500 1-month realized volatility is currently at 12, which is the lowest since January. And the VIX, a measure of the stock market’s expectation of volatility based on S&P 500 index options, has declined to the lowest since the pandemic started.
The decline in volatility appears to be linked to reduced interest rate volatility, the success of vaccine rollouts across domestic markets and the falling demand for volatility risk, according to the analysts.
“However, our options strategists expect the volatility risk premium will return toward 2021’s highs in the coming weeks,” Goldman Sachs analyst, David Kostin, said in the report.
There has also been a drop in trading activity, which is creating more calm in the equity markets.
“S&P 500 average trading volume as a share of market cap thus far in April has registered as the lowest since January 2020,” Kostin said.
The slowdown is particularly linked to retail trading. The analysts said online retail broker daily average trades are up about 75% year-over-year, which is a sharp drop from the peak of 250% in August 2020.
“Similarly, total US equity call option volumes have dropped to their lowest level since late 2020, albeit at still elevated levels by historical standards,” Kostin said.
What does the low volatility mean?
This low volatility has driven return dispersion below the long-term average, the analysts said.
Return dispersion can be expressed as a function of stock volatility and correlation, the analysts said, and tends to be low when volatility is low and stock correlations are high. Stock correlations are the relationships between stocks and their respective price movements.
The report highlights that the past decade has provided extremely low return dispersion. However, in 2020, the 3-month return dispersion reached its highest level since the financial crisis of 2008.
“Fund performance is often strongest during periods of high return dispersion, as the stockpicking opportunity set is wide and rewards effective bottom-up stock pickers,” Kostin said.
With return dispersion moving lower, below the long-term average of 28 percentage points, this creates a more challenging environment for stock pickers.
“We have previously shown that return dispersion has been the most significant factor in explaining adjusted mutual fund outperformance,” Kostin said.
The analysts expect the key catalysts for stocks to be micro in nature with the three main themes will be tax reform, infrastructure and pricing power. All three catalysts have company-specific impacts compared to the macro level catalyst seen earlier in the year, such as the election and the $1.9 trillion fiscal stimulus package.
“These micro-driven catalysts should keep stock correlations low, but a return to a high dispersion environment will be challenging without an increase in volatility,” Kostin said.
So, what should investors do in this challenging stock picking environment?
The analysts have created a framework to help identify stocks in the S&P 500 with the best alpha-generation potential based on the current outlook for return dispersion.
The strategy involves calculating a dispersion score, which is done by looking at the following:
1) The proportion of trailing 6-month returns driven by micro factors after controlling for market, sector, size and value.
2) The analysts forecast of the volatility associated with the proportion of return attributable to the micro factors.
Stocks that achieve high dispersion scores are the ones that are more likely to have heightened response to both good and bad company-specific (micro) news and present the best alpha generation opportunities, the analysts said.
“Rather, we believe these stocks allow investors the best opportunities to overlay our dispersion scores with views on near-term catalysts or the outlook for companies in order to maximize alpha generation,” Kostin said.
We break down the analysts 25 stocks with the best dispersion scores. The median dispersion score for the S&P 500 is 1.6.
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