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Big Ideas

These blog entries offer some big ideas of lasting value relevant for investing and trading.

Surviving by Staying Out of the Fourth Quadrant

Can one survive over the long run in the “wild” Fourth Quadrant, in which many investments appear to reside and for which normal (Gaussian) statistics mislead rather than guide? In his February 2009 draft paper entitled “Errors, Robustness, and The Fourth Quadrant”, Nassim Taleb investigates the (in)tractability of economic and financial series and characterizes approaches to accommodating such fundamental unpredictability. Based on a broad set of worldwide economic data that includes 38 tradable variables with daily price data, he concludes that: Keep Reading

Four Factors and Two Regimes

Do returns associated with the four famous factors (market, size, book-to-market, momentum) vary systematically with the state of the market (such as bull or bear)? In their January 2009 paper entitled “The Effect of Market Regimes on Style Allocation”, Manuel Ammann and Michael Verhofen investigate how returns for the four factors differ between market states as determined by a multivariate two-state model of the overall equity market. Using U.S. stock market and factor data spanning 1927-2004, they conclude that: Keep Reading

Predictable Pieces of the Market?

Are commonly used stock market indicators more predictive for some subsets of stocks than for the stock market overall? In the November 2008 update of their paper entitled “How Predictable are Components of the Aggregate Market Portfolio?”, Aiguo Kong, David Rapach, Jack Strauss, Jun Tu and Guofu Zhou analyze return predictability for various subsets of the overall U.S. stock market, defined by portfolios sorted into 33 industry, 10 market capitalization and 10 book-to-market ratio segments. They consider 14 economic variables and lagged returns for 33 industries as predictors. Using economic indicator and industry/size/book-to-market return data from the end of 1945 through 2004, they conclude that: Keep Reading

Different Paths to the Same (Disconcerting) Destination?

The Efficient Market Hypothesis (EMH) and the “Black Swan” Hypothesis (BSH) take very different paths to the same destination, as follows: Keep Reading

Stock Returns for New Industries

Do new industries offer exceptionally good stock returns, whether through strong growth or investor exuberance? In their September 2008 paper entitled “Returns to Investors in Stocks in New Industries”, Gerald Dwyer Jr. and Cora Barnhart examine stock return distributions and summary statistics for the following major new industries in the U.S. over the periods of their initial development (15-23 years): personal computers, airlines, aircraft manufacturing, automobile manufacturing, railroads and telegraph. Using return data for the stocks of companies in the selected industries and contemporaneous market indexes, they conclude that: Keep Reading

Factor Fishing Expedition

Many equity market researchers assume conventional three-factor (excess market return or beta, size, book-to-market ratio) and four-factor (plus momentum) models as standards of comparison for discovery of new sources of abnormal returns. Are they the best standards? In their November 2008 paper entitled “Fishing with a Licence: an Empirical Search for Asset Pricing Factors”, Soosung Hwang and Alexandre Rubesam investigate the empirical power of 12 previously identified asset pricing factors using a Bayesian variable selection method called Stochastic Search Variable Selection (see the paper for a description). The factor candidates are: excess market return, liquidity, coskewness, cokurtosis, downside risk, size, book-to-market ratio, momentum, asset growth, idiosyncratic volatility, volume and long-term reversal. Using data for thousands of individual U.S. stocks and associated firm characteristics, 25 factor-based portfolios and 30 industry portfolios over the period 1967-2006, they conclude that: Keep Reading

The Fourth Quadrant: No Realm for the Normal

New sample points from the past two months are substantially shifting correlations in several our past analyses of relationships between indicators and future stock returns (published updates pending). Here are some recent relevant observations from Nassim Taleb’s September 2008 essay in Edge entitled “The Fourth Quadrant: A Map of the Limits of Statistics”. In the aftermath of the collapse of Fannie Mae, Bear Stearns and Lehman Brothers, he observes that: Keep Reading

Sensitivity of Stock Market Return Predictability to Predictor Measurement Interval

Does the predictability of stock market returns depend on exactly when and for how long one measures the predictive variable? In the October 2008 draft of their paper entitled “Return Predictability Revisited”, Ben Jacobsen, Ben Marshall and Nuttawat Visaltanachoti anticipate a substantial fraction of the variation in monthly stock market returns by judiciously refining the observation intervals for a set of predictive variables (prices for the 22 commodities with the largest world production during 2003-2008). The causality chain is, presumably, commodity price changes affect future corporate earnings and/or inflation, and investor expectations about earnings and inflation affect equity valuation. The authors test the predictive power of commodity price changes over a range of measurement intervals under assumptions of both near efficiency (rapid response of equity prices to commodity prices) and gradual information diffusion (delayed response of equity prices). Using daily commodity spot prices as available and monthly stock market returns for the U.S. and 18 other countries since 1970, they conclude that: Keep Reading

Anomalies Tested with Expected (Rather Than Historical) Returns

Are the major known stock return anomalies as exploitable as they seem to investors looking back at historical returns? In their September 2008 paper entitled “Do Anomalies Exist Ex Ante?”, Ginger Wu and Lu Zhang examine a wide range of anomalies (book-to-market, composite issuance, net stock issues, abnormal investment, asset growth, price momentum, earnings surprises, total and discretionary accruals, net operating assets, and failure probability) from the perspective of a forward-looking investor. They employ in their analysis expected returns derived from growth rates of fundamentals (dividends, earnings, sales and equity), rather than backward-looking historical (realized) returns. Using monthly price and return data for a broad sample of stocks, along with contemporaneous firm fundamentals, over the period 1965-2007, they conclude that: Keep Reading

The Futility of Timing Emerging Equity Markets?

Can investors/traders outperform by exploiting (or avoiding) the black swans that populate daily emerging market equity returns? In his September 2008 paper entitled “Black Swans in Emerging Markets”, Javier Estrada investigates the influence of the best and worst days on long-term equity returns in emerging markets and the naive likelihood that investors can predict when these outliers will occur. Using evidence from 16 international equity markets and over 110,000 daily returns from start dates based on data availability through 2007, he concludes that: Keep Reading

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