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Value Investing Strategy (Strategy Overview)

Allocations for December 2020 (Preliminary)
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Momentum Investing Strategy (Strategy Overview)

Allocations for December 2020 (Preliminary)
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Economic Indicators

The U.S. economy is a very complex system, with indicators therefore ambiguous and difficult to interpret. To what degree do macroeconomics and the stock market go hand-in-hand, if at all? Do investors/traders: (1) react to economic readings; (2) anticipate them; or, (3) just muddle along, mostly fooled by randomness? These blog entries address relationships between economic indicators and the stock market.

U.S. Economy and Equity Market Linkage Weakening?

How connected are principal measures of U.S. economic activity and U.S. stock market performance? In their October 2020 paper entitled “Has the Stock Market Become Less Representative of the Economy?”, Frederik Schlingemann and René Stulz model and measure relationships between market capitalizations of U.S. publicly listed firms and their contributions to U.S. employment and Gross Domestic Product (GDP). They estimate employment contribution directly based on firm reports, with modeled adjustments. They measure contribution to GDP based on firm value-add, approximated as operating income before depreciation plus labor costs (with labor costs often modeled). They also try other ways of measuring value-add. Using annual non-farm employment and GDP data for the U.S., annual employment and value-add data for U.S. publicly listed firms and annual stock prices for those firms during 1973 (limited by firm employment data) through 2019, they find that:

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Inflation Forecast Update

The Inflation Forecast now incorporates actual total and core Consumer Price Index (CPI) data for October 2020. The actual total (core) inflation rate is a little lower than (a little lower than) forecasted.

Combining Economic Policy Uncertainty and Stock Market Trend

A subscriber requested, as in “Combine Market Trend and Economic Trend Signals?”, testing of a strategy that combines: (1) U.S. Economic Policy Uncertainty (EPU) Index, as described and tested separately in “Economic Policy Uncertainty and the Stock Market”; and, (2) U.S. stock market trend. We consider two such combinations. The first combines:

  • 10-month simple moving average (SMA10) for the broad U.S. stock market as proxied by the S&P 500 Index. The trend is bullish (bearish) when the index is above (below) its SMA10 at the end of last month.
  • Sign of the change in EPU Index last month. A positive (negative) sign is bearish (bullish).

The second combines:

  • SMA10 for the S&P 500 Index as above.
  • 12-month simple moving average (SMA12) for the EPU Index. The trend is bullish (bearish) when the EPU Index is below (above) its SMA12 at the end of last month.

We consider alternative timing strategies that hold SPDR S&P 500 (SPY) when: the S&P 500 Index SMA10 is bullish; the EPU Index indicator is bullish; either indicator for a combination is bullish; or, both indicators for a combination are bullish. When not in SPY, we use the 3-month U.S. Treasury bill (T-bill) yield as the return on cash, with 0.1% switching frictions. We assume all indicators for a given month can be accurately estimated for signal execution at the market close the same month. We compute average net monthly return, standard deviation of monthly returns, net monthly Sharpe ratio (with monthly T-bill yield as the risk-free rate), net compound annual growth rate (CAGR) and maximum drawdown (MaxDD) as key strategy performance metrics. We calculate the number of switches for each scenario to indicate sensitivities to switching frictions and taxes. Using monthly values for the EPU Index, the S&P 500 Index, SPY and T-bill yield during January 1993 (inception of SPY) through September 2020, we find that:

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Economic Policy Uncertainty and the Stock Market

Does quantified uncertainty in government economic policy reliably predict stock market returns? To investigate, we consider the U.S. Economic Policy Uncertainty (EPU) Index, created by Scott Baker, Nicholas Bloom and Steven Davis and constructed from three components:

  1. Coverage of policy-related economic uncertainty by prominent newspapers.
  2. Number of temporary federal tax code provisions set to expire in future years.
  3. Level of disagreement in one-year forecasts among participants in the Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters for both (a) the consumer price index (CPI) and (b) purchasing of goods and services by federal, state and local governments.

They normalize each component by its own standard deviation prior to 2012 and then compute a weighted average of components, assigning a weight of one half to news coverage and one sixth each to tax code uncertainty, CPI forecast disagreement and government purchasing forecast disagreement. They update the index monthly at the beginning of the following month, potentially revising recent months. Using monthly levels of the EPU Index and the S&P 500 Index during January 1985 through September 2020, we find that: Keep Reading

CPI and Stocks Over the Short and Intermediate Terms

Do investors reliably react over short and intermediate terms to changes in the U.S. Consumer Price Index (CPI), a logical measure of the wealth discount rate? Using monthly total and core (excluding food and energy) CPI releases (for all items, not seasonally adjusted) from the Bureau of Labor Statistics (BLS) and contemporaneous S&P 500 Index opens and closes during mid-January 1994 (earliest available CPI release dates) through mid-September 2020 (321 releases), we find that: Keep Reading

Asset Class ETF Interactions with the Yuan

How do different asset classes interact with the Chinese yuan-U.S. dollar exchange rate? To investigate, we consider relationships between WisdomTree Chinese Yuan Strategy (CYB) and the exchange-traded fund (ETF) asset class proxies used in the Simple Asset Class ETF Momentum Strategy (SACEMS) and the Simple Asset Class ETF Value Strategy (SACEVS) at a monthly measurement frequency. Using monthly dividend-adjusted closing prices for CYB and the asset class proxies during May 2008 (when CYB is first available) through August 2020 (147 months), we find that: Keep Reading

Asset Class ETF Interactions with the Euro

How do different asset classes interact with euro-U.S. dollar exchange rate? To investigate, we consider relationships between Invesco CurrencyShares Euro Currency (FXE) and the exchange-traded fund (ETF) asset class proxies used in the Simple Asset Class ETF Momentum Strategy (SACEMS) or the Simple Asset Class ETF Value Strategy (SACEVS) at a monthly measurement frequency. Using monthly dividend-adjusted closing prices for FXE and the asset class proxies since February 2006 as available through July 2020, we find that: Keep Reading

Asset Class ETF Interactions with the U.S. Dollar

How do different asset classes interact with U.S. dollar valuation? To investigate, we consider relationships between Powershares DB US Dollar Index Bullish Fund (UUP) and the exchange-traded fund (ETF) asset class proxies used in the Simple Asset Class ETF Momentum Strategy (SACEMS) or the Simple Asset Class ETF Value Strategy (SACEVS) at a monthly measurement frequency. Using monthly dividend-adjusted closing prices for UUP and the asset class proxies since March 2007 as available through July 2020, we find that: Keep Reading

SACEVS Input Risk Premiums and EFFR

The “Simple Asset Class ETF Value Strategy” (SACEVS) seeks diversification across a small set of asset class exchanged-traded funds (ETF), plus a monthly tactical edge from potential undervaluation of three risk premiums:

  1. Term – monthly difference between the 10-year Constant Maturity U.S. Treasury note (T-note) yield and the 3-month Constant Maturity U.S. Treasury bill (T-bill) yield.
  2. Credit – monthly difference between the Moody’s Seasoned Baa Corporate Bonds yield and the T-note yield.
  3. Equity – monthly difference between S&P 500 operating earnings yield and the T-note yield.

Premium valuations are relative to historical averages. How might this strategy react to changes in the Effective Federal Funds Rate (EFFR)? Using end-of-month values of the three risk premiums, EFFRtotal 12-month U.S. inflation and core 12-month U.S. inflation during March 1989 (limited by availability of operating earnings data) through July 2020, we find that: Keep Reading

Federal Reserve Treasuries Holdings and Asset Returns

Is the level, or changes in the level, of Federal Reserve (Fed) holdings of U.S. Treasuries (bills, notes, bonds and TIPS, measured weekly as of Wednesday) an indicator of future stock market and/or Treasuries returns? To investigate, we take dividend-adjusted SPDR S&P 500 (SPY) and iShares Barclays 20+ Year Treasury Bond (TLT) as tradable proxies for the U.S. stock and Treasuries markets, respectively. Using weekly Fed holdings of Treasuries, SPY and TLT during mid-December 2002 through early July 2020, we find that: Keep Reading

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