Objective research to aid investing decisions

Value Investing Strategy (Strategy Overview)

Allocations for November 2021 (Final)
Cash TLT LQD SPY

Momentum Investing Strategy (Strategy Overview)

Allocations for November 2021 (Final)
1st ETF 2nd ETF 3rd ETF

Bonds

Bonds have two price components, yield and response of price to prevailing interest rates. How much of a return premium should investors in bonds expect? How can investors enhance this premium? These blog entries examine investing in bonds.

Real Interest Rates and Asset Returns

How sensitive are returns of stocks, bonds and gold to levels real interest rates (nominal rates minus inflation)? To investigate, we consider three nominal interest rates and two measures of inflation, as follows:

These choices offer six alternative real interest rates. We use end-of-month interest rates and inflation measures lagged by one month to account for release delay. We use the S&P 500 Index (SP500) capital gain only, the 10-year yield (with bond prices moving inversely) and spot gold price, all measured end-of-month, to represent returns for stocks, bonds and gold. We then relate monthly changes in real interest rates to asset class monthly returns in two ways: (1) calculate correlations of monthly real interest rates to asset class returns for each of the next 12 months to get a sense of how real rates lead asset returns; and, (2) calculate average asset class monthly returns by ranked tenths (deciles) of prior-month real interest rates to discover any non-linear relationships. Using monthly PCEPI and Core PCEPI since January 1961, interest rates since January 1962, SP500 level since December 1961 and spot gold price since December 1974 (when controls are removed), all through May 2021, we find that:

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Best Safe Haven ETF?

A subscriber asked which exchange-traded fund (ETF) asset class proxies make the best safe havens for the U.S. stock market as proxied by the S&P 500 Index. To investigate, we test 14 ETFs as potential safe havens:

Utilities Select Sector SPDR (XLU)
iShares 20+ Year Treasury Bond (TLT)
iShares 7-10 Year Treasury Bond (IEF)
iShares 1-3 Year Treasury Bond (SHY)
iShares iBoxx $ Investment Grade Corporate Bond (LQD)
iShares Core US Aggregate Bond (AGG)
iShares TIPS Bond (TIP)
Vanguard REIT ETF (VNQ)
SPDR Gold Shares (GLD)
PowerShares DB Commodity Tracking (DBC)
United States Oil (USO)
iShares Silver Trust (SLV)
PowerShares DB G10 Currency Harvest (DBV)
SPDR Bloomberg Barclays 1-3 Month T-Bill (BIL)

We consider three ways of testing these ETFs as safe havens for the U.S. stock market based on daily or monthly returns:

  1. Contemporaneous return correlation with the S&P 500 Index during all market conditions at daily and monthly frequencies.
  2. Performance during S&P 500 Index bear markets as defined by the index being below its 10-month simple moving average (SMA10) at the end of the prior month.
  3. Performance during S&P 500 Index bear markets as defined by the index being -20%, -15% or -10% below its most recent peak at the end of the prior month.

Using daily and monthly dividend-adjusted closing prices for the 14 ETFs since respective inceptions, and contemporaneous daily and monthly levels of the S&P 500 Index since 10 months before the earliest ETF inception, all through late April 2021, we find that: Keep Reading

Simple Term Structure ETF/Mutual Fund Momentum Strategy

Does a simple relative momentum strategy applied to tradable U.S. Treasury term structure proxies produce attractive results by picking the best duration for exploiting current interest rate trend? To investigate, we run short-term and long-term tests. The short-term test employs four exchange-traded funds (ETF) to represent the term structure:

SPDR Barclays 1-3 Month T-Bill (BIL)
iShares 1-3 Year Treasury Bond (SHY)
iShares Barclays 7-10 Year Treasury Bond (IEF)
iShares Barclays 20+ Year Treasury Bond (TLT)

The second test employs three Vanguard mutual funds to represent the term structure:

Vanguard Short-Term Treasury Fund (VFISX)
Vanguard Intermediate-Term Treasury Fund (VFITX)
Vanguard Long-Term Treasury Fund (VUSTX)

For each test, we allocate all funds at the end of each month to the fund with the highest total return over a specified ranking (lookback) interval, ranging from one month to 12 months. To accommodate the longest lookback interval, portfolio formation commences 12 months after the start of the sample. We focus on compound annual growth rate (CAGR) and maximum drawdown (MaxDD) as key performance metrics. Using monthly dividend-adjusted closing prices for BIL since May 2007, for SHY, IEF and TLT since July 2002 and for VFISX, VFITX and VUSTX since October 1991, all through March 2021, we find that: Keep Reading

Real Bond Returns and Inflation

A subscriber asked (years ago): “Everyone says I should not invest in bonds today because the interest rate is so low (and inflation is daunting). But real bond returns over the last 30 years are great, even while interest rates are low. Could you analyze why bonds do well after, but not before, 1981?” To investigate, we consider the U.S. long-run interest rate and the U.S. Consumer Price Index (CPI) series from Robert Shiller. The long-run interest rate is the yield on U.S. government bonds, specifically the constant maturity 10-year U.S. Treasury note after 1953. We use the term “T-note” loosely to name the entire series. We apply the formula used by Aswath Damodaran to the yield series to estimate nominal T-note total returns. We use 12-month change in CPI. We subtract inflation from T-note nominal total return to get T-note real total return. Using annual Shiller interest rate and CPI data for 1871 through 2020, we find that: Keep Reading

Alternative Yield Discount (Inflation) Rates

Investors arguably expect that investments generate returns in excess of the inflation rate. Do different measures of the inflation rate indicate materially different yield discounts? To investigate, we relate 12-month trailing S&P 500 annual operating earnings yield (E/P), S&P 500 12-month trailing annual dividend yield, 10-year U.S. Treasury note (T-note) yield and 3-month U.S. Treasury bill (T-bill) yield to four measures of annual U.S. inflation rate:

  1. Non-seasonally adjusted inflation rate based on the total Consumer Price Index (CPI) from the Bureau of Labor Statistics (retroactive revisions of seasonal adjustments interfere with historical analysis).
  2. Non-seasonally adjusted inflation rate based on core CPI from the Bureau of Labor Statistics.
  3. Inflation rate based on the Personal Consumption Expenditures: Chain-type Price Index (PCE) from the Federal Reserve Bank of St. Louis.
  4. Trimmed mean PCE from the Federal Reserve Bank of Dallas.

Using monthly data for all variables during March 1989 (limited by earnings data) through December 2020, we find that… Keep Reading

Seasonal Timing of Monthly Investment Increments

A subscriber requested evaluation of three retirement investment alternatives, assuming a constant increment invested at the end of each month, as follows:

  1. 50-50: allocate each increment via fixed percentages to stocks and bonds (for comparability, we use 50% to each).
  2. Seasonal 1: during April through September (October through March), allocate 100% of each increment to stocks (bonds).
  3. Seasonal 2: during April through September (October through March), allocate 100% of each increment to bonds (stocks).

The hypothesis is that seasonal variation in asset class allocations could improve overall long-term investment performance. We conduct a short-term test using SPDR S&P 500 ETF Trust (SPY) as a proxy for stocks and iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) as a proxy for bonds. We then conduct a long-term test using Vanguard 500 Index Fund Investor Shares (VFINX) as a proxy for stocks and Vanguard Long-Term Investment-Grade Fund Investor Shares (VWESX) as a proxy for bonds. Based on the setup, we focus on terminal value as the essential performance metric. Using total (dividend-adjusted) returns for SPY and LQD since July 2002 and for VFINX and VWESX since January 1980, all through December 2020, we find that: Keep Reading

Ziemba Party Holding Presidency Strategy Update

“Exploiting the Presidential Cycle and Party in Power” summarizes strategies that hold small stocks (large stock or bonds) when Democrats (Republicans) hold the U.S. presidency. How has this strategy performed in recent years? To investigate, we consider three strategy alternatives using exchange-traded funds (ETF):

  1. D-IWM:R-SPY: hold iShares Russell 2000 (IWM) when Democrats hold the presidency and SPDR S&P 500 (SPY) when Republicans hold it.
  2. D-IWM:R-LQD: hold IWM when Democrats hold the presidency and iShares iBoxx Investment Grade Corporate Bond (LQD) when Republicans hold it.
  3. D-IWM:R-IEF: hold IWM when Democrats hold the presidency and iShares 7-10 Year Treasury Bond (IEF) when Republicans hold it.

We use calendar years to determine party holding the presidency. As benchmarks, we consider buying and holding each of SPY, IWM, LQD or IEF and annually rebalanced portfolios of 60% SPY and 40% LQD (60 SPY-40 LQD) or 60% SPY and 40% IEF (60 SPY-40 IEF). We consider as performance metrics: average annual excess return (relative to the yield on 1-year U.S. Treasury notes at the beginning of each year); standard deviation of annual excess returns; annual Sharpe ratio; compound annual growth rate (CAGR); and, maximum annual drawdown (annual MaxDD). We assume portfolio switching/rebalancing frictions are negligible. Except for CAGR, computations are for full calendar years only. Using monthly dividend-adjusted closing prices for the specified ETFs during July 2002 (limited by LQD and IEF) through December 2020, we find that:

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CAPE (P/E10) Version of Fed Model?

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

Add REITs to SACEVS?

What happens if we extend the “Simple Asset Class ETF Value Strategy” (SACEVS) with a real estate risk premium, derived from the yield on equity Real Estate Investment Trusts (REIT), represented by the FTSE NAREIT Equity REITs Index? To investigate, we apply the SACEVS methodology to the following asset class exchange-traded funds (ETF), plus cash:

3-month Treasury bills (Cash)
iShares 20+ Year Treasury Bond (TLT)
iShares iBoxx $ Investment Grade Corporate Bond (LQD)
SPDR Dow Jones REIT (RWR) through September 2004 dovetailed with Vanguard REIT ETF (VNQ) thereafter
SPDR S&P 500 (SPY)

This set of ETFs relates to four risk premiums, as specified below: (1) term; (2) credit (default); (3) real estate; and, (4) equity. We focus on effects of adding the real estate risk premium on gross compound annual growth rates (CAGR), maximum drawdowns (MaxDD) and annual Sharpe ratios of the Best Value (picking the most undervalued premium) and Weighted (weighting all undervalued premiums according to degree of undervaluation) versions of SACEVS. Using lagged quarterly S&P 500 earnings, monthly S&P 500 Index levels and monthly yields for 3-month U.S. Treasury bill (T-bill), the 10-year Constant Maturity U.S. Treasury note (T-note), Moody’s Seasoned Baa Corporate Bonds and FTSE NAREIT Equity REITs Index since March 1989 (limited by availability of earnings data), and monthly dividend-adjusted closing prices for the above asset class ETFs since July 2002, all through November 2020, we find that: Keep Reading

SACEVS Applied to Mutual Funds

“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):

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

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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