Equity Premium

Governments are largely insulated from market forces. Companies are not. Investments in stocks therefore carry substantial risk in comparison with holdings of government bonds, notes or bills. The marketplace presumably rewards risk with extra return. How much of a return premium should investors in equities expect? These blog entries examine the equity risk premium as a return benchmark for equity investors.

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Update SACEVS with End-of-quarter Instead of Quarterly Average Yields?

“Simple Asset Class ETF Value Strategy” (SACEVS) tests a simple relative value strategy that each quarter allocates funds to one or more of the following three asset class exchange-traded funds (ETF), plus cash, based on degree of undervaluation of measures of the term risk, credit risk and equity risk premiums:

3-month Treasury bills (Cash)
iShares 7-10 Year Treasury Bond (IEF)
iShares iBoxx $ Investment Grade Corporate Bond (LQD)
SPDR S&P 500 (SPY)

One version of SACEVS (Best Value) picks the most undervalued premium. Another (Weighted) weights all undervalued premiums according to degree of undervaluation. Premium calculations and SACEVS portfolio allocations derive from quarterly average yields for 3-month Constant Maturity U.S. Treasury bills (T-bills), 10-year Constant Maturity U.S. Treasury notes (T-notes) and Moody’s Seasoned Baa Corporate Bonds (Baa). A subscriber asked whether fresh end-of-quarter yields might work better than quarterly average yields. Using monthly S&P 500 Index levelsquarterly S&P 500 earnings and daily T-note, T-bill and Baa yields during March 1989 through March 2015 (limited by availability of earnings data), and quarterly dividend-adjusted closing prices for the above three asset class ETFs during September 2002 through March 2015 (154 months, limited by availability of IEF and LQD), we find that: Keep Reading

CFOs Project the Equity Risk Premium

How do the corporate experts most responsible for assessing the cost of equity currently feel about future U.S stock market returns? In their May 2015 paper entitled “The Equity Risk Premium in 2015″, John Graham and Campbell Harvey update their report on the views of U.S. Chief Financial Officers (CFOs) and equivalent corporate officers on the prospective U.S. equity risk premium (ERP) relative to the 10-year U.S. Treasury note (T-note) yield, assuming a 10-year investment horizon. Based on 60 quarterly surveys over the period June 2000 through March 2015 (an average 350 responses per survey), they find that: Keep Reading

Update SACEVS Monthly Instead of Quarterly?

“Simple Asset Class ETF Value Strategy” (SACEVS) tests a simple relative value strategy that each quarter allocates funds to one or more of the following three asset class exchange-traded funds (ETF), plus cash, based on degree of undervaluation of measures of the term risk, credit risk and equity risk premiums:

3-month Treasury bills (Cash)
iShares 7-10 Year Treasury Bond (IEF)
iShares iBoxx $ Investment Grade Corporate Bond (LQD)
SPDR S&P 500 (SPY)

One version of SACEVS (Best Value) picks the most undervalued premium. Another (Weighted) weights all undervalued premiums according to degree of undervaluation. Premium calculations and SACEVS portfolio allocations are quarterly per the arrival rate of new corporate earnings information. The principal benchmark is a quarterly rebalanced portfolio of 60% SPY and 40% IEF. A subscriber asked whether monthly SACEVS updates outperform quarterly updates. Using monthly S&P 500 Index levelsquarterly S&P 500 earnings and monthly average yields for 3-month Constant Maturity U.S. Treasury bills (T-bills), 10-year Constant Maturity U.S. Treasury notes (T-notes) and Moody’s Seasoned Baa Corporate Bonds during March 1989 through March 2015 (limited by availability of earnings data), and monthly dividend-adjusted closing prices for the above three asset class ETFs during September 2002 through March 2015 (154 months, limited by availability of IEF and LQD), we find that: Keep Reading

Lumber-Gold Interaction as Stocks and Bonds Indicator

Does the interaction of paradigmatic indicators of optimism (lumber demand) and pessimism (gold demand) tell investors when to take risk and when to avoid risk? In their May 2015 paper entitled “Lumber: Worth Its Weight in Gold: Offense and Defense in Active Portfolio Management”, Charles Bilello and Michael Gayed examine the recent relative performance of lumber (a proxy for economic activity via construction) and gold (a safe haven) as an indicator of future stock market and bond market performance. Specifically, if lumber futures outperform (underperform) spot gold over the prior 13 weeks, they go on offense (defense) the next week. They test this strategy on combinations of seven indexes comprising a spectrum of risk (listed lowest to highest): BofA Merrill Lynch 5-7 Year Treasury Index (Treasuries); CBOE S&P 500 Buy-Write Index (BuyWrite); S&P 500 Low Volatility Index (Low Volatility); S&P 500 Index (SP500); Russell 2000 Index (R2000); Morgan Stanley Cyclicals Index (Cyclicals); and, S&P 500 High Beta Index (High Beta). Using weekly nearest futures contract prices for random length lumber, weekly spot gold prices and weekly total returns for the seven test indexes during November 1986 (November 1990 for Low Volatility and High Beta) through January 2015, they find that: Keep Reading

Simple Asset Class Value and Momentum Diversification with Mutual Funds

“SACEMS-SACEVS Mutual Diversification” finds that the “Simple Asset Class ETF Value Strategy” (SACEVS) and the “Simple Asset Class ETF Momentum Strategy” (SACEMS) are mutually diversifying. Do the longer samples available for the “Simple Asset Class Value Strategy Applied to Mutual Funds” and the “Simple Asset Class Momentum Strategy Applied to Mutual Funds” confirm this finding? To check, we relate quarterly returns for the Best Value selections from the former and momentum winner (Top 1) mutual fund selections from the latter and look at the performance of an equally weighted portfolio of these two strategies (50-50). Using quarterly gross returns for the two strategies from the second quarter of 1998 through the first quarter of 2015, we find that: Keep Reading

2015 Country Risk-free Rates and Equity Risk Premiums

What are current estimates of local risk-free rates (RFR) and annual premiums over RFRs demanded in each country by equity investors (equity risk premium, or ERP)? In their April 2015 paper entitled “Discount Rate (Risk-Free Rate and Market Risk Premium) Used for 41 Countries in 2015: A Survey”, Pablo Fernandez, Alberto Ortiz and Isabel Acin summarize the results of a March-April 2015 email survey of international finance/economic professors, analysts and company managers “about the risk-free rate and the Market Risk Premium used to calculate the required return on equity in different countries.” Based on 4,573 specific and credible responses spanning 41 countries (those with at least 25 such responses), they find that: Keep Reading

SACEVS Performance When Stocks Rise and Fall

How differently does the “Simple Asset Class ETF Value Strategy (SACEVS)” perform when stocks rise and when stocks fall? This strategy seeks to exploit relative valuation of the term risk premium, the credit (default) risk premium and the equity risk premium via exchange-traded funds (ETF). To investigate, because the sample period available for mutual funds is much longer than that available for ETFs, we use instead the risk premium estimation methods (10-year rolling history of inputs) and strategy performance measurement approach from “Simple Asset Class Value Strategy Applied to Mutual Funds”, Specifically, each quarter we reform a Best Value portfolio (picking the asset associated with the most undervalued of the three premiums, if any) and a Weighted portfolio (weighting assets associated with all undervalued premiums according to degree of undervaluation) from the following four assets:

The benchmark is a quarterly rebalanced portfolio of 60% stocks and 40% U.S. Treasuries (60-40 VWUSX-VFIIX). We say that stocks rise (fall) during a quarter when the return for VWUSX is positive (negative). Using quarterly risk premium calculation data during January 1970 through March 2015, and quarterly dividend-adjusted closing prices for the three asset class mutual funds during June 1980 through March 2015 (140 quarters), we find that:

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SACEVS Performance When Interest Rates Rise

A subscriber asked how the “Simple Asset Class ETF Value Strategy (SACEVS)” performs when interest rates rise. This strategy seeks to exploit relative valuation of the term risk premium, the credit (default) risk premium and the equity risk premium via exchange-traded funds (ETF). To investigate, because the sample period available for mutual funds is much longer than that available for ETFs, we use instead the risk premium estimation methods (10-year rolling history of inputs) and strategy performance measurement approach from “Simple Asset Class Value Strategy Applied to Mutual Funds”, Specifically, each quarter we reform a Best Value portfolio (picking the asset associated with the most undervalued of the three premiums, if any) and a Weighted portfolio (weighting assets associated with all undervalued premiums according to degree of undervaluation) from the following four assets:

The benchmark is a quarterly rebalanced portfolio of 60% stocks and 40% U.S. Treasuries (60-40 VWUSX-VFIIX). We use the above T-bill yield as the short-term interest rate (SR) and the 10-year Constant Maturity U.S. Treasury note (T-note) yield as the long-term interest rate (LR). We say that each rate rises or falls when the associated average quarterly yield increases or decreases from quarter to quarter. Using quarterly risk premium calculation data during January 1970 through March 2015, quarterly average SR and LR, and quarterly dividend-adjusted closing prices for the three asset class mutual funds during June 1980 through March 2015 (140 quarters), we find that:

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Effects of Execution Delay on Simple Asset Class ETF Value Strategy

“Effects of Execution Delay on Simple Asset Class ETF Momentum Strategy” investigates how delaying signal execution affects strategy performance. How does execution delay affect the performance of the complementary Best Value version of the “Simple Asset Class ETF Value Strategy”? This latter strategy each quarter allocates all funds to the one of the following asset class exchange-traded funds (ETF) associated with the most undervalued risk premium (term, credit or equity), or to cash if none are undervalued:

3-month Treasury bills (Cash)
iShares 7-10 Year Treasury Bond (IEF)
iShares iBoxx $ Investment Grade Corporate Bond (LQD)
SPDR S&P 500 (SPY)

To investigate, we compare 23 variations of the strategy that all use end-of-quarter (EOQ) to determine the best value asset but shift execution from the contemporaneous EOQ to the next open or to closes over the next 21 trading days (about one month). For example, an EOQ+5 Close variation uses an EOQ cycle to determine winners but delays execution until the close five trading days after EOQ. Using daily dividend-adjusted opens and closes for the risk premium proxies and the yield for Cash from the end of September 2002 through the end of March 2015 (51 quarters), we find that:

Keep Reading

Comparison of Variable Retirement Spending Strategies

Do variable retirement spending strategies offer greater utility than fixed-amount or fixed-percentage strategies? In his March 2015 paper entitled “Making Sense Out of Variable Spending Strategies for Retirees”, Wade Pfau compares via simulation ten retirement spending strategies based on a common set of assumptions. He classifies these strategies into two categories: (1) those based on decision rules (such as fixed real spending and fixed percentage spending); and, (2) actuarial models based on remaining portfolio balance and estimated remaining longevity. His bases comparisons on 10,000 Monte Carlo runs for each strategy. He assumes a retirement portfolio of 50% U.S. stocks and 50% U.S. government bonds with initial value $100,000, rebalanced annually after end-of-year 0.5% fees and beginning-of-year withdrawals. He calibrates initial spending where feasible by imposing a probability of X% (X=10) that real spending falls below $Y (Y=1,500) by year Z of retirement (Z=30). He treats terminal wealth as unintentional (in fact, undesirable), with the essential trade-off between spending more now and having to cut spending later. He ignores tax implications. Using historical return data from Robert Shiller and current levels of inflation and interest rates (see the chart below), he finds that: Keep Reading

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Current Momentum Winners

ETF Momentum Signal
for June 2015 (Final)

Winner ETF

Second Place ETF

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ETF Value Signal
for 2nd Quarter 2015 (Final)

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The asset with the highest allocation is the holding of the Best Value strategy.
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