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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Preliminary Momentum Strategy Updates

The home page and “Momentum Strategy” now show preliminary asset class ETF momentum strategy positions for August 2015. The differences in past returns among the top three places is very small, and the gap between third and fourth places is not large. The top three positions could easily change by the close. The differences are not meaningful statistically, but we follow the strategy rules mechanically.

Effects of Execution Delay on SACEVS

“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 Best Value and Weighted versions of the “Simple Asset Class ETF Value Strategy” (SACEVS)? These strategies each month allocate funds to the following asset class exchange-traded funds (ETF) according to valuations of term, credit and equity risk premiums, or to cash if no premiums 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 21 variations of each strategy that all use end-of-month (EOM) to determine the asset allocations but shift execution from the baseline EOM+1 close to subsequent closes up to EOM+21. For example, an EOM+5 variation uses an EOM cycle to determine allocations but delays execution until the close five trading days after EOM. Using daily dividend-adjusted closes for the above ETFs and daily yields for Cash during August 2002 through June 2015 (154 months), we find that:

Keep Reading

SACEMS-SACEVS Mutual Diversification

Are the “Simple Asset Class ETF Value Strategy” (SACEVS) and the “Simple Asset Class ETF Momentum Strategy” (SACEMS) mutually diversifying. To check, we relate monthly returns for the SACEVS Best Value and the SACEMS Top 1 exchange-traded fund (ETF) selections and look at the performance of an equally weighted portfolio of these two strategies, rebalanced monthly (50-50). Using monthly gross returns for SACEVS Best Value and SACEMS Top 1 during January 2003 through June 2015, we find that: Keep Reading

Simple Asset Class ETF Value Strategy

Does a simple relative value strategy applied to tradable asset class proxies produce attractive results? To investigate, we test a simple strategy on the following three asset class exchange-traded funds (ETF), plus cash:

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

This set of ETFs relates to three factor risk premiums: (1) the difference in yields between Treasury bills and Treasury notes/bonds indicates the term risk premium; (2) the difference in yields between corporate bonds and Treasury notes/bonds indicates the credit (default) risk premium; and, (3) the difference in yields between equities and Treasury notes/bonds indicates the equity risk premium. We consider two alternative strategies 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% stocks and 40% U.S. Treasury notes (60-40 SPY-IEF). Using lagged quarterly S&P 500 earnings, end-of-month S&P 500 Index levels and end-of-month yields for the 3-month Constant Maturity U.S. Treasury bill (T-bill), the 10-year Constant Maturity U.S. Treasury note (T-note) and Moody’s Seasoned Baa Corporate Bonds during March 1989 through June 2015 (limited by availability of earnings data), and daily dividend-adjusted closing prices for the above three asset class ETFs during July 2002 through June 2015 (156 months, limited by availability of IEF and LQD), we find that: Keep Reading

SACEVS Modifications

We have made three changes to the “Simple Asset Class ETF Value Strategy” (SACEVS) based on results of  robustness tests and subscriber comments:

  1. To employ fresher data, we decrease the SACEVS S&P 500 Index level and bond/bill yield measurement interval from quarterly to monthly. S&P 500 Index operating earnings updates are still quarterly.
  2. To employ fresher data, we use end-of-measurement interval (end-of-month) bond/bill yields rather than average yields during the measurement interval.
  3. To account for a lag in availability of bill/bond yield data, we delay signal execution by one trading day.

These changes are logical, but introduce some additional noise. They result in somewhat higher risk-adjusted performance for SACEVS, at the expense of some additional trading. Effects on the Weighted version of the strategy are greater than those on the Best Value version.

We are updating “Value Strategy” and some related tests accordingly.

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

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Current Momentum Winners

ETF Momentum Signal
for August 2015 (Preliminary)

Winner ETF

Second Place ETF

Third Place ETF

Gross Compound Annual Growth Rates
(Since August 2006)
Top 1 ETF Top 2 ETFs
13.5% 14.0%
Top 3 ETFs SPY
14.0% 7.7%
Strategy Overview
Current Value Allocations

ETF Value Signal
for July 2015 (Final)

Cash

IEF

LQD

SPY

The asset with the highest allocation is the holding of the Best Value strategy.
Gross Compound Annual Growth Rates
(Since September 2002)
Best Value Weighted 60-40
13.0% 10.0% 8.0%
Strategy Overview
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