Idiosyncratic risk is dominating the equity markets

The intra-stock correlation is at market extremes. Dispersion measures are also high, suggesting very little common movement across stocks. Put differently, idiosyncratic risk is high. This means that we should be in a stock picker’s dream. Investors who can see distinct differences in individual stocks will be rewarded, while those focused on common behavior will be disadvantaged. However, the ability to make money in this environment is not a given. Just because stocks do not move together does not mean the stock-picker can identify winners. It does not mean stock betas will go to zero, but it does mean alpha should be more dispersed and residuals from any market regression should be higher. The equal-weighted index has outperformed the cap-weighted SPX index for the year and over the last 3 months.

More than a Korean bubble problem - US retail is selling

 

The bubble in Korea has been viewed by some as an isolated event. There is no question that Korean-specific regulation and behavior were a strong contributor to this bubble, yet we should look at what is happening in the US. One, the semiconductor sector is showing strong declines. Not like Korea, but the pattern is similar. Two, the move in the AI and IT sectors has been driven by retail, and retail within the US is reversing. The market is changing, and the marginal retail investor is a strong seller who is moving to more protective assets. 

Market sentiment is changing, and the positive forecasts in the last quarter are being revised. 

The equity maket sectors are getting more disperse

Using the v-Lab data, we are seeing that correlations across sectors in the US are falling and showing more dispersion. If the stock market, like all markets, can be viewed as a network, we are seeing the network expanding after a period of strong connection in the first quarter of 2025. We are seeing a disconnect in the IT sector but also across real market sectors. This can be viewed as a market for stock pickers.

 

A warning sign of a bubble? stock issuance

 

One of the key signs of a stock bubble is the issuance of new stock. Simply put, when the stock market is overvalued, smart firms will issue new stock to take advantage of these high values. The increase in supply will flood the market and generate downward pressure on stocks. We are seeing more issuance in the market this year, but it is not at extreme levels. The large increases in 2020-2021 were associated with SPACs, which cratered the following year. 

On the other hand, stock buybacks will occur when the stock market looks cheap, and CFOs want to increase their companies' stock prices. We are still seeing the numbers increase, although at a slower pace. 

What is important, and what we have not done here, is to adjust buybacks and issuance to the total stock market valuation, which may provide a better relative measure. In that case, buybacks may not seem as excessive, nor does issuance seem to be exceptional. There are still mixed signals on these CFO signals of overvalued stocks.

Say yes to corporate transparency

The SEC proposed that firms would only have to provide information on a semiannual basis. Yes, it is a burden on companies to provide quarterly reports, but what makes US markets so liquid and effective for all investors is that corporate information is readily available. Now, there may be some companies that pause about going public because of SEC regulations, but the solution is not to cut the amount of information provided to investors. Could there be a tightening of rules on what information is made available? Yes, this may be helpful, but cutting out core information by half is not the solution.

Goldman Sachs, based on survey data, found that almost 100% of respondents oppose the move to semi-annual reporting. The four leading reasons include transparency, timeliness, and protection. Do not change what most seem to believe is not broken. What are the people at the SEC thinking?

Dispersion - what does it mean?

 From the newsletter, Owenomics, we see that stock dispersion is at levels not achieved since 2008 and 2000. Now, this may not be an indicator of a market top, but it does tell us something about market behavior. 

Dispersion is not the same as volatility. Volatility measures deviations from the mean over a given time period. Dispersion measures the deviation of returns across a set of assets. It is a cross-sectional measure. Higher dispersion means there is a greater variation in the winners and losers relative to the mean return. This could mean there is a disruption in the current market regime or a rotation between industries and firms. It could mean there are a few very strong winners or losers.

Past periods of strong dispersion include the bursting of the tech bubble in 2000, the bursting of the housing bubble in 2008, and the Great Financial Crisis. Disruption leads to dispersion, but greater dispersion does not necessarily imply a general market decline.

Equities at the half year mark

 

Even with the Iran War, the equity markets are generally up double digits for the year, with the only laggard being the S&P top 50 firms. June seems to be seeing a notable rotation out of information technology and communication services and into other sectors, such as industrials and health care. There also seems to be a rotation from growth into quality, although momentum was still a market leader. The rotation theme also seems to indicate a shift from large-cap stocks to small caps. In fact, small caps have been the best-performing sector. 

US stocks are still performing well versus the rest of the world in June and for the year. Nevertheless, international equities showed strong performance for the quarter. Fixed income showed slight gains for the month and quarter, but commodities have continued to slide. 

Our biggest concern for the second half of the year is the risk of a correction from high valuations. A rise in rates or a slowdown in credit growth to stop an inflation surprise is a likely downside surprise. 

Earnings sustainability and equity returns

Nothing lasts forever. Many believe that trends are sustainable over the long term, but that is not the case, so today’s trend or growth rate may not tell us what will happen tomorrow. Too often, analysis compares two variables with the same timeframe when it is important to look to the future. In the case of long-term earnings growth, strong earnings today are not linked with strong forward performance. The chart above shows long-term earnings growth and compares it with forward earnings. There is a strong negative relationship. We should see forward earnings versus forward returns, and current earnings growth versus current returns, to close the loop on different combinations.

The end result is the same. Stock returns are tied to forward expectations, not what has happened currently or in the past.

Follow those small cap stocks; not the overvalued mega-caps

 

With all of the talk about the AI revolution and the Mag 7 over the last year, many investors have missed a really strong investment story - the rise of small-cap stocks. 

There has been a strong move in 2026, but more importantly, there is strong outperformance versus the megacaps. The market is signaling it wants to rotate out overvalued large caps and start putting money to work in smaller caps. Whether the story is about extreme overvaluation or opportunities in smaller, riskier names, the result is an opportunity that we have not seen for some time. There has been the view that the small-cap premium is dead, but there seems to be new life in these names that requires a second look.

Unsustained sales growth and AI

 

We are seeing very strong expectations for AI sales growth. There is no question that new technology will see stronger sales growth than the average firm and that, during the initial growth period, sales may be well above average. The question is, how do you temper these sales expectations to form more realistic estimates? The power of compounding will work against you. You can, of course, rely on some form of mean reversion, yet this can be guesswork.  

This problem was addressed in two papers by Counterpoint Global - Bayes and Base Rates: How History Can Guide Our Assessment of the Future and Bayes and Base Rates 2.0  I like this work because it takes the emotion out of the sales forecasts associated with AI and focuses on what we know across decades of data, within different industries, and with major changes in technology. We can form base rates using priors and then derive normal forecasts. The conclusion is that the sales forecasts are just too large, even if we isolate new technology, focus on specific industries, and account for the very best historical events. 

This does not mean investors should short these companies. It is unclear when reality will be realized, but arriving late is problematic, shorting can be a fool's game, but buying on these aggressive growth forecasts will be disappointing.  

What are equity markets discounting? it is not risk

 

The Iran conflict is not over, yet the markets are optimistic. Perhaps it is because we don’t know what to call this oil crisis. Is it a war? A dispute? A current pause? The SPX was up over 10% for the month. The high beta names were up over 15%. For the sector extremes, the communication services sector was up over 18%, while the energy sector was down 3.45%. Surprisingly, emerging markets were also up over 11% for the month and strongly higher over the last 12 months at 32%.  Even bonds were slightly higher for the aggregate index.Yet the market is facing a significant commodity shock, with the DJCI up 31% so far this year.

Is there anything to worry about? Central banks? Growth? Inflation? The markets are either looking through any negativity or do not believe it even exists. This is a path that should concern any investor. 

Attention versus earnings and momentum

 

One area of increasing research is the attention that is given to a specific market. Investors cannot follow everything, so there are different levels of attention. Given changing attention, there should be different levels of efficiency. What is found in the paper, "A Tale of Two Anomolies: The implications of investor attention for price and earnings momentum," is very interesting. Stocks that receive more attention exhibit greater price momentum and weaker earnings momentum. The authors make the following claim: investors pay less attention to earnings news, stock price underreacts, leading to stronger earnings momentum, but when attention is high, behavioral biases intensify, which fuels overreaction and price momentum. Depending on the type of attention, the effects will vary. 

There is no one beta - It changes across regimes

 

An interesting but simple paper, “Your Beta Is Wrong Regime-Dependent Alpha & Beta for Major Asset Classes”, explores the issue of regime-dependent beta. Your beta is not stationary, so alpha will not be stable but will move with the regime. This does not mean that you should calculate beta on a rolling basis; assume that beta is regime-dependent, and when the regime changes, so does the beta. Below are two examples of significant changes in beta. One shows silver, and the other is for Alphabet, one of the classic Mag 7 stocks. 

Do not assume there is one beta for any asset. This may seem obvious, but when seen in a distribution, the numbers are stark.

Retail investors love hard to value stocks

 

How do retail investors behave? I wish I knew. It seems that they have an increasing impact on some markets, but where is the focus? A paper titled "The Retail Habitat" seeks to answer this question and finds that retail investors prefer to trade hard-to-value stocks. Stocks with a lot of retail trading have more intangible capital, longer-duration cash flows, and are more likely to be mispriced. So why do retail investors focus on the harder-to-value names? The authors do not fully explore this critical issue. They just identify the stocks that seem to have more retail focus. I would suggets that that retail traders focus on big bets, the lottery tickets. The lottery ticket names, of course, will be stocks that can possibly produce large gains.

Is there a story for small caps?

 

If you look at the Shiller CAPE P/E values, the large-cap market looks expensive. If you look at small-cap stocks excluding the largest Mag 7 stocks, the market seems better positioned. Now that the small-cap risk premium has fallen, some have questioned its validity, but the number suggests a closer look.

If we just look at the 493 SPX stocks outside the Mag & there seems to be more value broadening investor focus. Of course, earnings for the Mag 7 have been higher, which justifies holding these stocks. Additionally, small-cap value and growth have not been rewarded. To hold these smaller-cap names, you truly have to believe that current P/E valuations are a strong predictor of short-term stock performance. Perhaps that is the case over the next five years, but it is a stretch for the next year.

Valuing start-ups mainly on scorecards

 

I came across this simple visual on the different methods for valuing start-up firms, and found that it does not follow a set format. Of the five methodologies, only one is based on DCF, a second is based on industry multiples, and the other three are focused on a scorecard. 

Should it be surprising that when assessing start-up companies, the focus is not on cash flow projections but on a narrative based on rankings? There is no clear idea for how to handicap or calculate risk, so there is a focus on creating characteristic rankings to form an overall ranking of potential success. 

When faced with uncertainty, other methods of analysis are needed to form a risk assessment. In this case, factor scorecards have been developed to solve the problem. 

The great equity reset - global dispersion

 

There is no question that this has been a great year for Communication Services and the Information Technology sector, which are up 34.88% and 24.36%, respectively, for the year through November. Still, we are seeing cracks in these sectors with differentiation across the Mag 7. What remains the key theme to watch is the rotation into global equities and emerging markets, which are up respectively by 29.84% and 22.40% through November. These indices are beating large, mid, and small-cap US stocks by a significant margin.  

Buying a broad set of US stocks is not the direction for success in the equity markets. We are seeing low correlation across US stocks and high dispersion. Investors need to be selective with their stock choices. This is a global stock-pickers market. If you are not a stock picker, you can see it in the differentials across risk premia. High beta and momentum factors are showing strong returns, while low volatility and dividend stocks are underperforming, even amid the current talk of market bubbles. 

Global equity correlations falling - flows following cheapness

The overall tendency for correlation across global equity indices is high, given strong economic integration across countries and the multinational business of large-cap stocks. Nevertheless, we note the current decline in equity correlations. The US is obviously moving higher on tech (Mag 7) and strong valuations. We note that the Mag 7 is showing increased dispersion, and valuations outside of tech are more reasonable; however, perceptions and flows suggest a decoupling as investors look for cheaper investment opportunities. The theme of seeking international cheap valuations will drive investor focus in 2026.

Equity markets overvalued, but what should you do?

 

The talk of overvaluation always has to be placed in context. It has to be given a number. High P/E levels are associated with lower future returns. This is a strong headwind. Does this mean that stocks will fall soon? That is less clear. The equity risk premium is falling, but it is still wider than it was during the tech bubble. There is also evidence that forward returns will be higher than what is predicted by valuations. 

Our concern is the catalyst that will cause a decline. High valuations coupled with macro shocks are the combination that will send stocks lower. The real macro economy is not as healthy as many think. Consumer sentiment is lower. Survey diffusion data is at best neutral but tends to suggest a slower economy. Shipping is down. While the Fed may not lower rates because of inflation worries, there should be growing concern about economic growth.

There are no stocks to trade

When looking at the reasons for the rise in private equity investing, we cannot dismiss the role of fewer publicly traded stocks. Over the last 30 years, the number of listed companies has declined by 50%. Of course, the decline of public and rise of private equity is caused by some other factor. It could be the cost of regulatory requirements associated with being listed. It could be an advantage to work with a limited number of investors over a diverse set, regardless of the regulation. No matter the reasons, fewer companies are easily traded by investors on exchanges. The choices have fallen, and the diversification possibilities have declined.