Today’s stock market presents a complex picture with the S&P 500 index showing low levels of both trailing and implied volatility, despite ongoing geopolitical conflicts and advancements in AI technology. Some experts argue that the apparent calm in the market is deceptive given the significant return volatility observed in individual stocks this year, with notable examples such as Intel and Sandisk, which have seen their values double in a single month.
Read More
Understanding this apparent contradiction in market conditions can be aided by a formula that represents the relationship between market return variance and the variance of its constituent stocks. Essentially, market variance equals individual stock variance minus cross-sectional dispersion.
These concepts can serve as both retrospective statistical reviews of historical data and forecasts of future trends. The options market also provides insights into market expectations, with indices calculated by the Cboe: VIX for market volatility, VIXEQ for individual stock volatility, and DSPX for dispersion.
Today’s stock market is compared to a duck that appears placid on the surface while paddling vigorously below. In this analogy, individual stock volatility drives market volatility upward, while rising cross-sectional dispersion pulls it downward, creating a seeming calm above but turbulent activity beneath.
A historical analysis of the three options-based measures since June 2014 indicates that the current level of the VIX is around its average, influenced by individual stock volatility and pushed down by dispersion, which is currently very high. For instance, VIXEQ is above the 97th percentile, and DSPX is above the 99th percentile.
When comparing today’s market conditions to tumultuous periods like those in March 2020 during the COVID outbreak and in April 2025 with tariff announcements, a pattern emerges. In those instances, both dispersion and individual stock volatility increased concurrently, leading to higher overall market volatility. In contrast, the current rise in individual stock volatility is partially offset by increased dispersion.
Moreover, the Cboe provides an index of implied correlation, COR1M, which illustrates that with a calm VIX and a high VIXEQ, implied correlation is notably low. Currently, COR1M is roughly 8%, significantly below the historical average.
The high dispersion and low correlation observed can be rationally attributed to the differential impact of AI-related information on various companies. Additionally, sentiment-based explanations suggest that AI enthusiasm is leading to overvaluation for some stocks and undervaluation for others, generating pronounced return dispersion.
Investors have high idiosyncratic volatility during periods of elevated market prices and active retail trading, often experiencing high volatility during subsequent corrections.
Critically, the notion that passive investing is currently distorting stock prices is challenged by the existing conditions of low correlation and high dispersion, contrasting a scenario where passive flows would typically yield high correlation.
For those invested in the entire index, high dispersion is favorable as it suggests that individual stock volatility is less impactful overall. However, low correlation and high dispersion can historically precede disappointing market returns. This pattern was notably observed near market peaks.
In summary, while investors holding the index may experience smoother sailing, those with portfolios not aligned with market weights will face greater risks and exposure to volatility. As of now, market dynamics show no signs of stabilizing.