Equity markets are off to a solid start in 2025. Despite an array of headline risks, the S&P 500 has climbed over 3% on the year and even notched a record high last month. Within the index, returns have also become more dispersed, pointing to a growing opportunity set for active management.
The rising dispersion in returns and relatively low correlation among S&P 500 stocks has become increasingly apparent on the CBOE S&P 500 Dispersion Index and the CBOE One-Month Implied Correlation Index.
The dispersion index compares the prices of S&P 500 constituent stock options and S&P 500 index options to quantify market expectations for how differently individual stocks are likely to perform relative to each other.
A higher index level implies higher expectations for wider deviations in returns within the S&P 500, and with higher dispersion comes more opportunities for alpha generation via active management. The correlation index quantifies the expected average correlation among S&P 500 stocks over a rolling one-month period.
Higher readings imply higher expectations for stocks to move more in tandem, while lower values suggest the market is pricing in more independent moves within the S&P 500.
Greater Dispersion and Lower Correlations Create Alpha Opportunities for Active Management
Source: LPL Research, Bloomberg 02/13/25
Disclosures: Indexes are unmanaged and cannot be invested in directly. Past performance is no guarantee of future results.
As part of LPL’s active management process, our Strategic and Tactical Asset Allocation Committee (STAAC) employs a combination of qualitative analysis done by an experienced team of subject matter experts (mind) and quantitative analysis of fundamental and technical analysis factors (machine) to arrive at tactical asset allocation decisions. This “mind and machine” approach led to two sector changes this month.
First, the STAAC upgraded consumer discretionary to overweight from neutral. From a qualitative and fundamental standpoint, consumer spending remains resilient, the trajectories for earnings and cash flows are supportive, and the sector has generally grown into its valuations. Technically, the sector remains in a rising price channel, with strong momentum, breadth, and relative performance.
Second, the STAAC downgraded materials to underweight from neutral. Despite the recent rebound in performance this year (the sector is up over 5% year to date), the fundamental backdrop for the materials space continues to underwhelm.
Of the 22 of 28 sector stocks out with fourth-quarter results, only 68% beat bottom-line estimates, while less than a quarter topped revenue estimates. This compares to the broader S&P 500 earnings and revenue beat rates of 76% and 54%, respectively. Moreover, the sector has witnessed significant downward earnings revisions for the calendar year 2025 over the last few months.
From a technical perspective, a relief rally off oversold levels has propelled the sector to its 2021 highs. A close above 572 would reclaim this key resistance level and the 200-day moving average (DMA). Support sets up at the January lows near 523.
However, breadth and momentum in the sector are waning. The Percent Price Oscillator (PPO) — a momentum indicator based on the relationship between two moving averages — is converging toward a potential sell signal. Relative strength also remains a concern. The materials sector vs. S&P 500 ratio chart has been trending lower for the past two years. The lack of support and bearish momentum in this trend suggests continued underperformance for the sector ahead.
Materials Underperformance
Source: LPL Research, Bloomberg 02/13/25
Disclosures: Indexes are unmanaged and cannot be invested in directly. Past performance is no guarantee of future results.
Summary
The S&P 500 is closing in on record-high territory. Underneath the surface, stock returns have become more dispersed, resulting in historically low correlations among constituents. This backdrop provides more alpha-generating opportunities for active management.
Disclaimer: LPL Research’s STAAC recently made several tactical allocation changes, including an upgrade of consumer discretionary to overweight and a downgrade of the materials sector to underweight. For the broader market, LPL Research continues to believe solid economic growth, strong earnings, and disinflation will power stocks higher this year. Plus, the technical picture remains positive, and historical patterns such as the January Barometer add to a compelling bull case. However, as we learned this week, the inflation battle is not over;, stocks are pricing in a lot of good news, and the policy landscape is tenuous. With more tariffs and retaliation likely, alongside government spending constraints that may make it difficult to extend the Trump tax cuts from 2017, we expect modest gains in stocks over the balance of the year with more ups and downs compared to 2024.