Blog - Investing Notes

For complete reverse chronological listings of blog entries, see:

External (Secondary) Research for summaries of working papers and published articles written by others.
Original (Primary) Research for summaries of original research.
Reviews for a few discussions of books, web sites and products.
Reader Q&A for interactions with readers that do not involve substantial analysis but may be of general interest.

Investing Demons provides a construct for synthesizing much of the research from past blog entries.

The Latest

March 18, 2010 - Inflation Forecast Update

The Inflation Forecast now incorporates the actual inflation rate for February 2010, which is lower than predicted. This mismatch will cause upward adjustments in the outputs of the Real Earnings Yield Model at the end of March.

March 18, 2010 - Short-term Reversal by Industry

Various studies find that returns on individual stocks exhibit tendencies for short-term (one month) reversal, medium-term (3-12 months) momentum and long-term (2-5 years) reversal. The short-term reversal is the basis for the skip-month included in some medium-term momentum strategies. Is there a way to concentrate the short-term reversal? In the March 2010 update of their draft paper entitled "Industries and Stock Return Reversals", Allaudeen Hameed, Joshua Huang and Mujtaba Mian examine monthly return reversal using stocks grouped into 24 industries, reasoning that such groups share common sources of return correlations. Using return, industry and characteristics data for a broad sample of NYSE/AMEX stocks spanning 1963-2006, they conclude that:

A hedge strategy that is long (short) the equally weighted fifth of stocks that are the biggest losers (winners) the prior month within each of the 24 industries, reformed monthly and weighting industries equally, generates an average monthly return of 1.46%. A comparable portfolio executed across the total sample of stocks generates an average monthly return of only 1.05%. The standard deviation of monthly reversal returns is 2.9% (4.1%) for the intra-industry (total sample) strategy. (See the charts below.)
- Semiconductors & Semiconductor Equipment (Software & Services) have the largest (smallest) intra-industry average monthly reversal of 3.1% (0.79%).
- Intra-industry reversals are stronger for illiquid, small and highly volatile stocks, suggesting that liquidity risk is an important source of short-run reversals.
- Skipping a week between the one-month formation and holding periods eliminates the the short-term reversal effect for the total sample of stocks, but not for industry groups.
Stocks that outperform or underperform the total sample but not their industries tend to exhibit momentum rather than reversal. A hedge strategy that capitalizes on both this inter-industry momentum and intra-industry reversals produces a raw (risk-adjusted) average monthly return of 2.3% (2.0%). This strategy produces positive returns for 77% of sample months.

The following charts, taken from the paper, compare month-by-month returns for hedge strategies that are long (short) the equally weighted fifth of stocks that are the biggest losers (winners) the prior month, reformed monthly. The top chart shows returns for this strategy applied across the total sample of stocks (unconditional), while the second shows returns for the strategy applied separately to 24 equally-weighted industries (industry sorted). The third chart shows the differences between the latter and former monthly returns. Results indicate that: (1) reversal returns are persistent over time; (2) intra-industry reversal returns are less volatile than total sample reversal returns; and, (3) intra-industry reversal returns tend to be larger than total market reversal returns.

Return estimates apparently do not account for any trading frictions, which could be substantial.

In summary, evidence suggests that investors can concentrate the short-term (one month) stock return reversal effect by focusing at the industry level.

The role of liquidity risk and the inter-industry momentum effect described above imply that short-term reversal may not be evident in broad, value-weighted market indexes.

For related research, see Blog Synthesis: Momentum Investing/Trading.

March 17, 2010 - Update: The "Best" Equity Risk Premium

What are the different ways of estimating the equity risk premium, and which one is the best? In the February 2010 update of his paper entitled "Equity Risk Premiums (ERP): Determinants, Estimation and Implications - A Post-crisis Update", Aswath Damodaran offers a comprehensive overview of equity risk premium estimation and application. Using data from multiple countries (but focusing on the U.S.) over long periods, he concludes that: More...

March 16, 2010 - Diversifying Across Equity Anomalies

Is diversification across equity anomalies beneficial? In his December 2009 preliminary paper entitled "Diversification Across Characteristics", Erik Hjalmarsson combines long-short portfolios formed on seven stock anomalies:

Short-term (one-month) reversal (ST-R)
Medium-term (11 months plus skip-month) momentum (Mom)
Long-term (four years plus skip-year) reversal (LT-R)
Book-to-market value (B/M)
Cash flow-to-price ratio (C/P)
Earnings-to-price ratio (E/P)
Market capitalization (Size)

The portfolio for each anomaly is long (short) on an equally weighted basis the tenth of stocks expected to generate the most positive (negative) returns, reformed each month. Using monthly firm characteristics and return data for all NYSE, AMEX and NASDAQ stocks over the period July 1951 through December 2008, he finds that: More...

March 15, 2010 - Doing Momentum with Style (ETFs)

The blog entry of 3/25/09 concludes that "a trader who periodically switches to the hottest known anomaly based on a rolling window of past performance may be able to beat the market. Anomalies appear to have their own kind of momentum." Does momentum therefore work for style-based exchange-traded funds (ETF)? To investigate, we apply a simple momentum strategy to the following six ETFs that cut across capitalization (large, medium and small) and value versus growth:

iShares Russell 1000 Value Index (IWD) - large capitalization value stocks.
iShares Russell 1000 Growth Index (IWF) - large capitalization growth stocks.
iShares Russell Midcap Value Index (IWS) - mid-capitalization value stocks.
iShares Russell Midcap Growth Index (IWP) - mid-capitalization growth stocks.
iShares Russell 2000 Value Index (IWN) - small capitalization value stocks.
iShares Russell 2000 Growth Index (IWO)- small capitalization growth stocks.

The simple (6-1) strategy allocates all funds each month to the one style ETF with the highest total return over the past six months. A six-month ranking period is intuitively large enough to gauge style momentum but small enough to react to changes in business conditions that might favor one style over others. Using monthly dividend-adjusted closing prices for the style ETFs and S&P Depository Receipts (SPY) over the period 8/01-2/10 (103 months, limited by data for IWS/IWP), we find that: More...

March 14, 2010 - How About Doug Casey?

A reader asked: "Can you evaluate Doug Casey in Guru Grades?" More...

March 13, 2010 - How About Roger Conrad?

A reader asked: "Can you evaluate Roger Conrad in Guru Grades?" More...

March 12, 2010 - How Do You "Purify" VIX?

A reader asked: "In 'Purifying Stock Market Sentiment Indicators', you say 'VIX purified of price action contains significant predictive power for future stock market returns.' How do you 'purify' the VIX of price action?" More...

March 12, 2010 - Refining the Accrual Anomalies

Are there ways to concentrate the predictive power of accruals for future individual stock and equity market returns? Two recent papers explore potential refinements. In the January 2010 draft of their paper entitled "Predicting Stock Market Returns with Aggregate Discretionary Accruals", Qiang Kang, Qiao Liu and Rong Qi focus on whether aggregate discretionary accruals (distinguished from normal accruals) are a better predictor of stock market returns than aggregate total accruals. In their February 2010 paper entitled "Percent Accruals", Nader Hafzalla, Russell Lundholm and Matt Van Winkle investigate scaling firm-level accruals by earnings rather than total assets to predict returns for individual stocks. These studies conclude that: More...

March 11, 2010 - Newsworthy Hedge Funds Underperform?

Do hedge funds covered by the news media underperform "hidden gems?" In their March 2010 paper entitled "Does Recognition Explain The Media-Coverage Discount? Contrary Evidence From Hedge Funds", Gideon Ozik and Ronnie Sadka examine the effects of media coverage on future hedge fund performance. Using results of 80,000 monthly searches of the Google News archive and monthly return data for 978 hedge funds spanning 1999-2008, they conclude that: More...

March 10, 2010 - Review of the VT26 Volatility Breakout Strategy

A reader commented and asked: "It seems there are indeed systems in Collective2 that make money on a walk-forward basis even considering trading frictions. VT26 is one of them (for autotrading at Collective2, you can assume on average $8.50 per contract per round turn). How does this stand versus your skeptical approach?" The author of VT26 describes it briefly as a 100% automated volatility breakout system with priorities on steady profits and small drawdowns. He provides further description of the strategy in "Report on Systematic Portfolio VT26." Using trade-by-trade data for VT26 for the period 4/9/08 through 3/8/10 (2,279 closed trades over 23 months across ten futures markets), we find that: More...

March 9, 2010 - Managing Investment Risk by Parsing Uncertainties

How scientific can economics and finance be? In the March 2010 draft of their paper entitled "WARNING: Physics Envy May Be Hazardous To Your Wealth!", Andrew Lo and Mark Mueller present a framework to help investors, portfolio managers, regulators and policymakers understand the potential effectiveness and inherent limitations of economics and finance. Focusing on levels of uncertainty (fully reducible, partially reducible, and irreducible) to explain some of the key differences between finance and physics and on the role of quantitative models in theory and practice, they conclude that: More...

March 8, 2010 - What About a Hedged Sector Momentum Strategy?

Scott Oyen of Scott's Investments asked: "Have you considered hedging an equal-weighted portfolio of the top three sector ETFs based on six-month momentum with a short position in the S&P 500 Index (via ProShares Short S&P500 - SH)? By adding a short position in the broad index, volatility and drawdowns could decrease." More...

March 8, 2010 - Perspectives on Global Equity Diversification

Given the sometimes high correlations in movements among local equity markets, how valuable is international diversification in a global era? In the February 2010 draft of their paper entitled "International Diversification Works (in the Long Run)", Clifford Asness, Roni Israelov and John Liew examine the argument that global markets are undiversified (correlated) when you need diversification and diversified (uncorrelated) when you don't. They use an equally weighted 22-country global portfolio for their investigation. Using monthly local currency-denominated total returns, exchange rates and inflation data for Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, Netherlands, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, UK and U.S. for 1950-2008, they conclude that: More...

March 6, 2010 - Moneyness and the Profitability of Shorting Equity Options

Covered Calls Advisor Jeff Partlow commented: "Selling a cash-secured put is essentially equivalent to a covered call when done at the same strike price and expiration date. But I've observed that cash-secured put sellers tend to select more conservative out-of-the-money strike prices, whereas covered call sellers tend to establish more aggressive out-of-the-money strike prices. Also, the result in 'Outperformance from Mechanically Selling Covered Calls on a Stock Index' is questionable to me because the July 2004 'Passive Options-based Investment Strategies: The Case of the CBOE S&P 500 BuyWrite Index' by Ibbotson Associates and the October 2006 'An Historical Evaluation of the CBOE S&P 500 BuyWrite Index Strategy' by Callan Associates show, respectively, that 2% out-of-the-money and at-the-money covered call strategies outperform a buy-and-hold approach." More...

March 5, 2010 - Amplifying Momentum Returns with Idiosyncratic Volatility

Does positive feedback trading, indicated by an adjusted measure of return autocorrelation, enhance momentum profitability? In the February 2010 version of their paper entitled "Positive Feedback Trading Activities and Momentum Profits", Thomas Chiang, Xiaoli Liang and Jian Shi examine the relationship between positive feedback trading and profitability of momentum strategies. The momentum parameters for their investigation are a six-month ranking interval followed by a six-month holding interval. Measurement of positive feedback trading is for a six-month window coinciding with the momentum ranking interval. Using daily stock return data for a broad sample of U.S. stocks spanning 1985-2005, they conclude that: More...

March 4, 2010 - Update: Preliminary Test of RYT Model Daily Valuations

Since 7/9/09, Christophe Faugère has been publishing (almost) daily "Market Estimates" of the value of the S&P 500 Index based on Required Yield Theory (RYT). RYT views investors as: (1) requiring that U.S. stocks and bonds in aggregate prospectively provide a real after-tax yield directly related to real long-term GDP per capita growth; and then, (2) deciding between stocks and bonds based on the better after-tax real return. To test the predictive power of these market estimates, we focus on daily percentage mismatches between estimated and actual values of the S&P 500 Index [(Estimated-Actual)/Actual] and exploitability of these mismatches via S&P Depository Receipts (SPY). Using daily RYT market estimates and daily levels of the S&P 500 Index and SPY over the period 7/9/09 through 3/3/10 (160 daily model outputs), we find that: More...

March 3, 2010 - Housing Price Reversion to Trend

Do real housing prices revert to some trend? If so, where do they stand now with respect to trend? In their February 2010 paper entitled "The Margin of Safety and House Price Turning Points: Observations from the US, the UK and Japan", Mitsuru Mizuno and Isaac Tabner investigate real housing price deviation from and reversion to trend in three developed markets. Using quarterly measures of housing price, inflation, disposable income, GDP and rent from 1960 (UK), 1963 (U.S.) and 1977 (Japan) through 2009, they conclude that: More...

March 2, 2010 - How About Martin Armstrong? (Updated 3/3/10 to append a reader comment)

A reader asked: "Can you look into the predictions of Martin Armstrong? He may be one of the most interesting and out-of-the-box thinkers on the markets. He supposedly predicted the 1987 crash, the Japanese crash and the top of our real estate market to the day." More...

March 2, 2010 - Unfooled by Randomness?

Can people reliably distinguish between actual financial markets time series and randomized data? In the February 2010 draft of their paper entitled "Is It Real, or Is It Randomized?: A Financial Turing Test", Jasmina Hasanhodzic, Andrew Lo and Emanuele Viola report the results of a web-based experiment designed to test the ability of people to distinguish between time series of returns for eight commonly traded financial assets (including stock indexes, a bond index, currencies and commodities, all given names of animals) and randomized data. Using a sample of 8015 guesses from 78 participants over eight contests conducted during 2009, they conclude that: More...

March 1, 2010 - The Performance of Individual Chinese Investors

Does the experience of individual investors in China confirm that trading tends to transfer wealth from individuals to institutions? Are there groups of individual investors who excel? In their February 2010 draft paper entitled "Do All Individual Investors Lose by Trading?", Wei Chen, Zhuwei Li and Yongdong Shi examine the trading performance of three categories of individual investors segmented by account size and several categories of institutional investors. Using the complete transaction history and account information of all traders on the Shenzhen Stock Exchange (68.4 million individual and institutional accounts) to construct portfolios that mimic the buys and sells of each investor group over the period 2002-2007, they conclude that: More...

February 27, 2010 - Is Buying Just-delisted Stocks a Profitable Strategy?

A reader asked: "I read a few papers that suggest buying delisted stocks when they begin trading OTC is a profitable strategy. Do you have any evidence to support this claim?" More...

February 26, 2010 - Combining E/P and B/P

Are stock earnings yield (E/P) and firm book-to-price ratio (B/P) complementary indicators of future stock returns? In their December 2009 paper entitled "Returns to Buying Earnings and Book Value: Accounting for Growth and Risk", Francesco Reggiani and Stephen Penman investigate the interplay of E/P and B/P in an accounting context, including joint implications for future stock returns. The authors hypothesize that B/P measures the degree to which firms defer recognition of risky earnings. Using monthly stock return and firm financial data for a broad sample of U.S. stocks spanning 1963-2006 (153,858 firm-years over 44 years), they find that: More...

February 25, 2010 - Why the Experts Don't Rule the World?

Why does the public resist the wisdom of scientific consensus on "questions only they [scientists] are equipped to answer?" In their February 2010 article entitled "Cultural Cognition of Scientific Consensus", Dan Kahan, Hank Jenkins-Smith and Donald Braman examine the tendency of individuals to perceive risk with biases congenial to their visions of how society should be organized. The authors focus on the examples of climate change, disposal of nuclear waste and the effect of permitting concealed possession of handguns. They measure individual cultural predisposition along two dimensions: hierarchy versus egalitarianism, and individualism versus communitarianism. Using results of an online survey of 1,500 U.S. adults during July 2009, they conclude that: More...

February 24, 2010 - Deconstructing Effects of Corporate News

What types of corporate news have the most impact on stock price? In their February 2010 paper entitled "Market Reaction to Corporate News and the Influence of the Financial Crisis", Andreas Neuhierl, Anna Scherbina and Bernd Schlusche analyze immediate stock return, volatility and liquidity reactions to various types of corporate news (focusing on one day before to five days after release date). They segment news releases into nine major categories and 52 subcategories. Using a comprehensive sample of 285,917 corporate press releases carried by all major news wire services between April 2006 and August 2009, they find that: More...

February 23, 2010 - Refined Short-term Reversal Strategies

Does short-term (one-month) stock return reversal persist? If so, is there a best way to refine and exploit it? In the February 2010 version of their paper entitled "Decomposing the Short-term Return Reversal", Zhi Da, Qianqiu Liu and Ernst Schaumburg investigate total market and intra-industry short-term price reversals and segment the intra-industry component according to expected return, cash flow news reaction and discount rate news reaction. Using monthly data for a broad sample of relatively large and liquid stocks accounting for about 75% of U.S. equity market capitalization over the period January 1982 through March 2008, they conclude that: More...

January 30, 2010 - Impossibly Good? (Updated 2/22/10 to append comments from Swing-Trading.net CEO Sinisa Persich)

A reader asked: "The performance on Swing-Trading.net must have 200 trades, and no losers. How is that possible?" More...

February 22, 2010 - The Return on Stamps

Do stamps provide a good return compared to equities? Can investors use stamps to hedge against inflation? In the February 2010 version of their paper entitled "Ex Post: The Investment Performance of Collectible Stamps", Elroy Dimson and Christophe Spaenjers investigate the returns on British collectible postage stamps over the long term. Using Stanley Gibbons stamp catalog prices to construct a value-weighted British stamp price index/returns and returns for other asset classes over the period 1900-2008, they conclude that: More...

February 20, 2010 - Can You Simplify the Description of this ETF Pair Trading Strategy?

A reader asked: "I find it really hard to follow the academic language in "Market Timing & Trading Strategies Using Asset Rotation". Can you simplify?" More...

February 19, 2010 - Simple Gold-Gold Stock Fund Pair Trading

A reader asked about the gold-gold stocks arbitrage-like argument in Jay Kaeppel's 2/2/10 article "Don't Give Up On Gold Stocks Just Yet", for which his 9/21/04 article "Gold Stock and Gold Bullion" is a more robust antecedent. Does the relationship between gold and gold stocks support more frequent switching than indicated in these articles? For example, if SPDR Gold Shares (GLD) have outperformed (underperformed) a gold/precious metals stock fund over the past quarter, does it then tend to underperform (outperform)? Using weekly adjusted closes for GLD and Market Vectors Gold Miners GDX) since inception (November 2004 and May 2006, respectively) through mid-February 2010 and for Rydex Precious Metals (RYPMX) over the same period as that for GLD, we find that: More...

February 19, 2010 - Inflation Forecast Update

The Inflation Forecast now incorporates the actual inflation rate for January 2010, which is slightly lower than predicted. This mismatch will cause slight upward adjustments in the outputs of the Real Earnings Yield Model at the end of February.