Indicator of the Week: Are We Headed for a Stock Picker's Market?

Foreword: The biggest craze right now in financial management seems to be passive investing. According to Morningstar Direct, U.S. passive equity funds had inflows of $166.6 billion in 2014, compared to $98.4 billion in outflows for active equity funds (as reported by Zacks). Investors seem to have been persuaded by the often lower fees charged for passive funds and evidence that active funds hardly do any better than their benchmark indexes. With passive investing having become so popular, it comes natural to me as a contrarian to look for evidence that active stock pickers are about to make a comeback.

Correlation Measures: It's tough predicting how active managers will perform, but higher stock dispersions will surely help their chances. For example, if every single stock performed equally, then active managers would have no opportunities to outperform indexes. Here's a method I came up with to examine the opportunities available for active managers. Looking at optionable liquid stocks, I found their six-month returns and compared them to the six-month return for the S&P 500 Index (SPX). Then, I found the median return of all the stocks that outperformed the SPX and the median return that underperformed the SPX. I assume the wider the spread between those two measures, the more opportunities there are for active managers to find outperforming equities.

Applying that method, I get the chart below. As you can see, 2014 showed historically low stock dispersions using this method. No wonder passive funds have been so easy to market. It was a year where there were few opportunities for active managers. Late in 2014, the spread began increasing, and earlier this year it hit its highest level since 2012. If this trend continues, it could mean more opportunities for active stock pickers -- which could lead to better returns, assuming they take advantage of those opportunities.

Next is a chart forecasting lower correlation among stocks, and therefore more opportunities for stock pickers. It's the CBOE S&P 500 Implied Correlation Index, which rotates among ticker symbols ICJ, JCJ, and KCJ over different time frames (ICJ was used for this study). Using implied volatilities on individual stocks and on the SPX, it shows the implied correlation among stocks in the index. The correlation index has fallen dramatically since late 2014.

To sum up the above, passive stock selection seems to be all the rage right now, which naturally gets contrarians like me skeptical. There has been an increase in stock dispersions recently, meaning more opportunities for active fund managers. Option markets are predicting lower stock correlations going forward, which would again point to more opportunity for active fund managers. It would not surprise me if 2015 marked the beginning of a stock picker's market.