Bonds

How does the Cyclically Adjusted Price-to-Earnings ratio (CAPE, or P/E10) behave during the COVID-19 pandemic? What are its current implications? In the November 2020 revision of their paper entitled “CAPE and the COVID-19 Pandemic Effect”, Robert Shiller, Laurence Black and Farouk Jivraj examine behavior of CAPE during 2020 in the U.S., UK, Europe, Japan and China, highlighting the impact of the pandemic. They apply CAPE to generate current 2-year, 5-year and 10-year equity return forecasts based on full-sample regressions. They then extend the CAPE forecasting approach to forecast changes in excess real return of stocks over bonds (see the chart below) to explore why investors strongly prefer equities over bonds during the pandemic. Finally, they look at sector dynamics within each economy. Using Shiller data during January 1871 through September 2020, they find that: Keep Reading

“Simple Asset Class ETF Value Strategy” (SACEVS) finds that investors may be able to exploit relative valuation of the term risk premium, the credit (default) risk premium and the equity risk premium via exchange-traded funds (ETF). However, the backtesting period is limited by available histories for ETFs and for series used to estimate risk premiums. To construct a longer test, we make the following substitutions for potential holdings (selected for length of available samples):

• Monthly average 3-Month Treasury Bill (T-bill) Secondary Market Rate instead of monthly average 3-Month T-bill Constant Maturity Rate as the risk-free rate and return on Cash.
• Vanguard GNMA Investor Shares (VFIIX) instead of  iShares 20+ Year Treasury Bond (TLT).
• Vanguard Long-Term Investment Grade Investor Shares (VWESX) instead of iShares iBoxx $ Investment Grade Corporate Bond (LQD).
• Vanguard 500 Index Fund Investor Shares (VFINX) instead of SPDR S&P 500 (SPY).

To enable estimation of risk premiums over a longer history, we also substitute:

• Monthly average Moody’s Seasoned Baa Corporate Bond Yields rather than day before end-of-month Baa yields for calculation of the credit risk premium. This substitution ignores a one-day delay in release of daily data.
• Robert Shiller’s S&P Composite Index monthly average levels instead of S&P 500 Index monthly closes. This substitution ignores any delay in posting of Shiller data (but new data are available elsewhere in real time).
• Robert Shiller’s monthly S&P Composite Index (GAAP, or as-reported) earnings instead of S&P Dow Jones S&P 500 operating earnings. We lag the Shiller earnings by four months to ensure real-time availability. In other words, the earnings yield for a month is the S&P Composite Index level for that month divided by index annual GAAP earnings as of four months ago. GAAP earnings are generally lower than operating earnings (see “Stock Market Valuation Ratio Trends”).
• Robert Shiller’s monthly average Long Interest Rates instead of monthly average yields on 10-year Constant Maturity U.S. Treasury notes. This substitution ignores any delay in posting of Shiller data (but new data are again available elsewhere with little delay).

As with ETFs, we consider two alternatives for exploiting premium undervaluation: Best Value, which picks the most undervalued premium; and, Weighted, which weights all undervalued premiums according to degree of undervaluation. Based on the assets considered, the principal benchmark is a monthly rebalanced portfolio of 60% VFINX and 40% VFIIX. Using monthly risk premium calculation data during March 1934 through November 2020 (limited by availability of T-bill data), and monthly dividend-adjusted closing prices for the three asset class mutual funds during June 1980 through November 2020 (40+ years, limited by VFIIX), we find that:

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Is there a better way than the Fed model to measure relative attractiveness of equities and bonds. In his October 2020 paper entitled “Towards a Better Fed Model”, Raymond Micaletti examines seven Fed Model alternatives, each comparing a 10-year forward annualized estimate of equity returns to the yield of 10-year constant maturity U.S. Treasury notes (T-note). The seven estimates of future equity returns are based on autocorrelation-corrected quarterly regressions using 10 years of past quarterly data for one of: (1) Aggregate Investor Allocation to Equities (AIAE); (2) Cyclically-Adjusted Price-to-Earnings Ratio (CAPE); (3) Tobin’s Q (QRATIO); (4) Market Capitalization-to-Nominal GDP (MC/GDP); (5) Market Capitalization-to-Adjusted Gross Value Added (MC/AGVANF); (6) Market Capitalization-to-Household and Non-Profit Total Assets (MC/HHNPTA); and, (7) Household and Non-Profit Equity Allocation-to-Nominal GDP (HHNPEQ/GDP). He calculates AIAE as total market value of equities divided by the sum of total market value of equities and total par value of bonds, approximated by adding the liabilities of five categories of borrowers. He then tests for each alternative a tactical asset allocation (TAA) strategy that each month weights equities and bonds based on a modified z-score of the forecasted 10-year equity risk premium (equity return minus T-note yield) computed by subtracting the median and dividing by the standard deviation of actual monthly premiums over the past 10 years. If modified z-score is greater than 1 (less than -1), the strategy is 100% in equities (0% in equities). In between those thresholds, weights are based on linear interpolation. Using quarterly data from the Archival Federal Reserve Economic Database (ALFRED) and Robert Shiller’s data library and daily U.S. equity market returns and U.S. Treasury bond/note roll-adjusted futures returns as available from the end of the fourth quarter of 1951 through the end of the third quarter of 2020, he finds that: Keep Reading

A subscriber asked about a strategy that switches between an equal-weighted portfolio of Invesco QQQ Trust (QQQ) and iShares Russell 2000 ETF (IWM) when the S&P 500 Index is above its 200-day simple moving average (SMA200) and an equal-weighted portfolio of SPDR Gold Shares (GLD) and iShares 20+ Year Treasury Bond ETF (TLT) when below. Also, more generally, is an equal-weighted portfolio of GLD and TLT (GLD:TLT) superior to TLT only for risk-off conditions? To investigate, we (1) backtest the switching strategy and (2) compare performances of GLD:TLT versus TLT when the S&P 500 Index is below its SMA200. We consider both gross and net performance, with the latter accounting for 0.1% portfolio switching frictions 0.001% daily portfolio rebalancing frictions (rebalancing one hundredth of portfolio value). As benchmarks, we consider buying and holding SPDR S&P 500 ETF Trust (SPY) and a strategy that holds SPY (TLT) when the S&P 500 Index is above (below) its SMA200. Using daily S&P 500 Index levels starting February 5, 2004 and daily dividend-adjusted levels of QQQ, IWM, GLD, TLT and SPY starting November 18, 2004 (limited by inception of GLD), all through November 25, 2020, we find that:

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“Market Impacts of Growth in Target Date Funds” summarizes research on potential market-wide effects of periodic rebalancing actions of Target Date Funds (TDF), which trade against momentum. One piece of evidence is that monthly autocorrelation of S&P 500 Index returns is significantly negative during 2010-2019 but not during 1986-1995 or 1996-2005. Another is that TDFs accomplish most of quarterly rebalancing within the next quarter. To assess how convincing autocorrelation findings are, we calculate rolling 5-year monthly (60-month) and quarterly (20-calendar quarter) autocorrelations of returns for:

• SPDR S&P 500 ETF Trust (SPY) since January 1993 to represent the U.S. stock market.
• Fidelity Fund (FFIDX) since January 1980 to represent the U.S. stock market
• Fidelity Investment Grade Bond Fund (FBNDX) since January 1980 to represent the U.S. bond market.

Using monthly total (dividend-reinvested) returns for these three assets through October 2020, we find that: Keep Reading

Are aggregate periodic stocks-bonds rebalancing actions of Target Date Funds (TDF), which trade against momentum, increasingly affecting U.S. stock market dynamics? In their October 2020 paper entitled “Retail Financial Innovation and Stock Market Dynamics: The Case of Target Date Funds”, flagged by a subscriber, Jonathan Parker, Antoinette Schoar and Yang Sun examine market impacts of Target Date Funds (TDFs), assets of which have grown from less than $8 billion in 2000 to more than $2.3 trillion (of roughly $21 trillion in U.S. mutual funds) in 2019. Using quarterly data on TDF holdings, monthly U.S. stock market and Vanguard Total Bond Market Index Fund (bond market) returns and monthly data for stocks held by and similar to those held by TDFs during the third quarter of 2008 through the fourth quarter of 2018 (excluding three quarters with suspect data), they find that:

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How should investors think about the interactions between working years (retirement account contributions) and retirement years (retirement account withdrawals)? In his June 2020 paper entitled “Retirement Planning: From Z to A”, Javier Estrada integrates working and retirement periods to estimate how much an individual should save and how they should invest to achieve a desired retirement income and ultimate bequest to heirs. He illustrates his analytical solution empirically for U.S. stocks and bonds, first using a base case plus sensitivity analysis and then using Monte Carlo simulations. His base case assumes:

• Work will last 40 years with a 60%/40% stocks/bonds retirement portfolio.
• Retirement will last 30 years with beginning-of-year real (inflation-adjusted) withdrawals of $60,000 from a 40%/60% stocks/bonds retirement portfolio and ultimate bequest $300,000.

Using annual data for U.S. stocks (the S&P 500 Index total return), bonds (10-year U.S. Treasury notes) and U.S. inflation during 1928 through 2019, he finds that: Keep Reading

Are government bond returns exploitably predictable? In their June 2020 paper entitled “Predicting Bond Returns: 70 Years of International Evidence”, Guido Baltussen, Martin Martens and Olaf Penninga examine predictability of international 10-year government bond returns with emphasis on two subsamples, January 1950 through September 1981 (mostly rising interest rates) and October 1981 through May 2019 (mostly falling rates). They consider five predictive variables, each transformed into a binary signal:

1. Yield spread – 10-year government bond yield minus the cash rate, standardized relative to historical values.
2. Bond trend – sign of past 12-month 10-year government bond return.
3. Past equity return – past 12-month equity index return in excess of cash return, standardized relative to historical values.
4. Past commodities return – past 12-month commodity index excess return, standardized relative to historical values.
5. Combination – equal-weighted combination of signals 1 through 4.

They use a spliced 10-year government bond sample, using excess return on a representative bond index before inception of associated futures and futures returns thereafter. Using monthly returns for 10-year government bond indexes/futures and cash rates for Australia, Canada, Germany, Japan, UK and U.S. during January 1950 (except October 1961 for Japan) through May 2019 (7,497 monthly returns), they find that: Keep Reading

“Verification Tests of the Smart Money Indicator” performs tests of ideas and setup features described in “Smart Money Indicator for Stocks vs. Bonds”. The Smart Money Indicator (SMI) is a complicated variable that exploits differences in futures and options positions in the S&P 500 Index, U.S. Treasury bonds and 10-year U.S. Treasury notes between institutional investors (smart money) and retail investors (dumb money) as published in Commodity Futures Trading Commission Commitments of Traders (COT) reports. Since findings for some variations in that test are attractive, we add two further robustness tests:

• Extend the sample period in “Verification Tests of the Smart Money Indicator” through the end of March 2020 to see how SMI performs during the 2019 coronavirus (COVID-19) stock market crash.
• Using the same setup as in “Verification Tests of the Smart Money Indicator”, test alternate definitions of commercial traders as smart money and non-commercial traders as dumb money (from legacy reports), rather than asset manager/institutional traders and non-reportables, respectively (from more granular disaggregated reports).

Using COT report data, dividend-adjusted SPDR S&P 500 (SPY) as a proxy for a stock market total return index, 3-month Treasury bill (T-bill) yield as return on cash (Cash) and dividend-adjusted iShares 20+ Year Treasury Bond (TLT) as a proxy for government bonds during 6/16/06 through 4/3/20, we find that:

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As implied in “Mirror Image Seasonality for Stocks and Treasuries?”, are bonds better than stocks during the “Sell-in-May” months of May through October? Are behaviors of government, corporate investment grade and corporate high-yield bonds over this interval similar? To investigate, we test seasonal behaviors of:

SPDR S&P 500 (SPY)
Vanguard Intermediate-Term Treasury (VFITX)
Fidelity Investment Grade Bond (FBNDX)
Vanguard High-Yield Corporate Bond (VWEHX)

Using dividend-adjusted monthly prices for these funds during January 1993 (limited by SPY) through January 2020, we find that: Keep Reading