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A Five-Factor Model of Differences in Stock Returns

Which factors are most predictive of differences in future returns among individual stocks? In their September 2007 paper entitled “Efficient Estimation of a Semiparametric Characteristic- Based Factor Model of Security Returns”, Gregory Connor, Matthias Hagmann and Oliver Linton develop a new method for analyzing the influence of simple fundamental and technical factors on the returns of individual stocks. The method accommodates consideration of additional factors more readily than widely used alternative approaches. Using monthly return data and associated fundamentals for a broad sample of stocks over the period 1962-2005, they find that: Keep Reading

No Fire Exit at the Overcrowded Hedge Fund Party?

Have hedge funds proliferated, grown and leveraged to the point that groups of them with similar quantitative strategies can crash as they try to exit common positions in response to some external trigger? In their September 2007 paper entitled “What Happened To The Quants In August 2007?”, Amir Khandaniy and Andrew Lo investigate the hypothesis that similar market-neutral and long/short equity hedge funds suffered a cascading fire sale liquidation (one-month losses of 5%-30%) during early August 2007. Using daily return data for a broad set of stocks to model hedge fund performance over the period 1/95-8/07, they tentatively conclude that: Keep Reading

Characteristics of Persistently Outperforming Hedge Funds

In his recent PhD thesis entitled “An Analysis of Hedge Fund Strategies”, Daniel Capocci offers an epic study of hedge fund properties, results and potential benefits. Specifically, he: (1) applies a multi-factor performance analysis model to determine the degree to which hedge funds persistently produce alpha; (2) measures the extent to which market-neutral hedge funds are really neutral; and, (3) examines the mean, volatility, skewness and kurtosis of hedge fund returns to evaluate their potential benefits to investors. Using hedge fund performance data from several sources spanning 1993-2003, he finds that: Keep Reading

Anger Management Training for Traders?

Do strong emotions generally help or hinder trading? How do outperforming traders handle their emotions? In the 2007 paper entitled “Being Emotional during Decision making – Good or Bad? An Empirical Investigation”, flagged by reader Dennis Page, Myeong-Gu Seo and Lisa Feldman Barrett investigate the role of emotions in stock trading via a simulation involving 101 traders recruited from investment clubs and paid $100 to $1,000 based on performance during the simulation. Using the self-reported emotional states of these traders during simulated buy-sell decisions on 12 available stocks each day for 20 consecutive trading days, they conclude that: Keep Reading

The Disconnected Federal Funds Rate?

In seeking to control interest rates, has the Federal Reserve become less relevant to equity investors? In his September 2007 paper entitled “The Unusual Behavior of the Federal Funds and 10-Year Treasury Rates: A Conundrum or Goodhart’s Law?”, Daniel Thornton examines the loss of correlation between the Federal Funds Rate (FFR) and long-term interest rates in the context of Goodhart’s Law, which states that “any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.” Using monthly data for the FFR and the yields for Treasury instruments of various durations over the period 1/83-3/07, he concludes that: Keep Reading

Crude Oil Price and Energy Sector ETF Returns

After reviewing our update of the relationship between crude oil price and overall stock market behavior, a reader requested a similar analysis of the relationship between crude oil price and an energy sector Exchange-Traded Fund (ETF) such as Energy Select Sector S&P Depository Receipts (XLE). The reader’s hypothesis is that energy ETFs follow crude oil spot price fairly well. Comparing the weekly crude oil spot price for the U.S. with the weekly close for XLE for over the period 1/99-8/07, we find that: Keep Reading

Crude Oil Price and Stock Returns

Some market commentators cite the price of crude oil as an important indicator of future stock market behavior. Is expensive crude oil a sign of future inflation or a drag on aggregate corporate earnings, or is it a proxy for general economic strength? Does a local peak (valley) in the price of crude oil portend a falling (rising) overall stock market? Comparing the weekly crude oil spot price for the U.S. with the weekly level of the S&P 500 index for the period 1/97-8/07, we find that… Keep Reading

The Out-of-Country Experiences of Individual U.S. Investors

How and why do individual U.S. investors diversify internationally? How significantly does this diversification affect their portfolio results? In their April 2007 paper entitled “Foreign Investments of U.S. Individual Investors: Causes and Consequences”, Warren Bailey, Alok Kumar and David Ng analyze the motivations and consequences of foreign equity investment by individual U.S. investors. Using personal characteristics and portfolio/trading data from tens of thousands of individual brokerage accounts at a major U.S. discount broker for the period 1/91-12/96, they conclude that: Keep Reading

Is 40% Per Month Shorting Index Puts a Fair Return?

Selling put options, with limited upside and potentially very large downside, seems very risky. Are actual returns from selling puts commensurate with the risk? In the May 2004 version of his paper entitled “Why are Put Options So Expensive?”, Oleg Bondarenko confirms large returns for shorting puts options on futures for a broad market index and investigates whether these large returns: (1) represent normal risk premiums; (2) are reasonably priced protection against market crashes; or, (3) indicate incorrect investor beliefs about the probability of negative market returns (crashes). Using a flexible testing methodology and daily price data for put options on S&P 500 index futures during 8/87-12/00, he concludes that: Keep Reading

The “Double 9-to-1 Up Day” Signal

Mark Hulbert’s 9/5/07 column addresses the 9-to-1 up day event, a bullish technical signal publicized by Martin Zweig in a 1986 book. It occurs when at least 90% of daily NYSE volume belongs to advancing issues. When the signal occurs in multiples over short periods, as it has recently, prospects for equities are “quite bullish” according to Mark Hulbert. A reader comments and inquires:

“A statistician [David Aronson, author of Evidence-Based Technical Analysis: Applying the Scientific Method and Statistical Inference to Trading Signals] confirms the significance of Zweig’s original observation. I don’t know whether he considered all possible confounding factors, such as low volume days, effect of externalities on the market, and others I can’t think of. This analysis sounds like so much epidemiological research, finding associations but never proving causality. For example, in the decade of the 1980s, alternate papers found that coffee consumption (greater than three cups per day) is and is not associated with increased risk of cancer of the pancreas. How much credence do you place in Hulbert’s article?”

Using S&P 500 index data for 1942-2006 (67 years), David Aronson finds an average return of about 5.2% in the 60 trading days after double 9-to-1 up days, significantly greater than the average return of about 1.1% during intervals of 60 trading days when there has not been such a signal. To follow up, we pose some questions to David Aronson and then consider strategies an investor might employ to exploit double 9-to-1 up day signals, as follows: Keep Reading

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