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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.

Productivity and the Stock Market

Financial media often cite Bureau of Labor Statistics (BLS) productivity growth news releases as relevant to investment outlook. Does the quarter-to-quarter change in U.S. labor force productivity predict U.S. stock market behavior? Specifically, does a relatively weak (strong) change in productivity portend strong (weak) earnings and therefore an advance (decline) for stocks? Using annualized quarterly changes in non-farm labor productivity from BLS and end-of quarter S&P 500 Index levels during January 1950 through March 2019, we find that: Keep Reading

Usefulness of Published Stock Market Predictors

Are variables determined in published papers to be statistically significant predictors of stock market returns really useful to investors? In their November 2018 paper entitled “On the Economic Value of Stock Market Return Predictors”, Scott Cederburg, Travis Johnson and Michael O’Doherty assess whether strength of in-sample statistical evidence for 25 stock market predictors published in top finance journals translates to economic value after accounting for some realistic features of returns and investors. Predictive variables include valuation ratios, volatility, variance risk premium, tail risk, inflation, interest rates, interest rate spreads, economic variables, average correlation, short interest and commodity prices. Their typical investor makes mean-variance optimal allocations between the stock market and a risk-free security (yielding a fixed 2% per year) via Bayesian inference based on a vector autoregression model of market return-predictor dynamics. The investor has moderate risk aversion and a 1-month or longer investment horizon (reallocates monthly). Stock market returns and predictors exhibit randomly varying volatility. They focus on annual certainty equivalent return (CER) gain, which incorporates investor risk aversion, to quantify economic value of market predictability. Using monthly U.S. stock market returns and data required to construct the 25 predictive variables as available (starting as early as January 1927 and as late as June 1996 across variables) through December 2017, they find that:

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Short-term Equity Risk More Political Than Economic?

How does news flow interact with short-term stock market return? In their April 2019 paper entitled “Forecasting the Equity Premium: Mind the News!”, Philipp Adämmer and Rainer Schüssler test the ability of a machine learning algorithm, the correlated topic model (CTM), to predict the monthly U.S. equity premium based on information in news articles. Their news inputs consist of about 700,000 articles from the New York Times and the Washington Post during June 1980 through December 2018, with early data used for learning and model calibration and data since January 1999 used for out-of-sample testing. They measure the U.S. stock market equity premium as S&P 500 Index return minus the risk-free rate. Specifically, they each month:

  1. Update news time series arbitrarily segmented into 100 topics (with robustness checks for 75, 125 and 150 topics).
  2. Execute a linear regression to predict the equity premium for each of the 100 topical news flows.
  3. Calculate an average prediction across the 100 regressions.
  4. Update a model (CTMSw) that switches between the best individual topic prediction and the average of 100 predictions, combining the flexibility of model selection with the robustness of model averaging.

They use the inception-to-date (expanding window) average historical equity premium as a benchmark. They include mean-variance optimal portfolio tests that each month allocate to the stock market and the risk-free rate based on either the news model or the historical average equity premium prediction, with the equity return variance computed from either 21-day rolling windows of daily returns or an expanding window of monthly returns. They constrain the equity allocation for this portfolio between 50% short and 150% long, with 0.5% trading frictions. Using the specified news inputs and monthly excess return for the S&P 500 Index during June 1980 through December 2018, they find that:

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ISM PMI and Future Junk Bond Returns?

A subscriber asked about the validity of the assertion in “The Daily Shot” of February 26, 2019 (The Wall Street Journal) that “recent weakness in the ISM [Institute for Supply Management] Manufacturing PMI [Purchasing Managers’ Index] index points to downside risks for high-yield debt.” Such a relationship might support a strategy of switching between high-yield bonds and cash, or high-yield bonds and U.S. Treasuries, based on PMI data. To investigate, we consider the following two pairs of funds:

  1. Vanguard High-Yield Corporate (VWEHX) and Vanguard Long-Term Treasury (VUSTX) since May 1986 (limited by VUSTX).
  2. iShares iBoxx High Yield Corp Bond (HYG) and iShares 7-10 Year Treasury Bond (IEF) since April 2007 (limited by HYG).

We consider both statistical tests and strategies that each month (per the PMI release frequency) holds high-yield bonds or cash, or high-yield bonds or Treasuries, according to whether the prior-month change in PMI is positive or negative. We use the 3-month U.S. Treasury bill (T-bill) yield as a proxy for return on cash. Using fund monthly total returns as available and monthly seasonally adjusted PMI data for January 1950 through January 2016 from the Federal Reserve Bank of St. Louis (discontinued and removed) and from press releases thereafter, all through February 2019, we find that: Keep Reading

Most Effective U.S. Stock Market Return Predictors

Which economic and market variables are most effective in predicting U.S. stock market returns? In his October 2018 paper entitled “Forecasting US Stock Returns”, David McMillan tests 10-year rolling and recursive (inception-to-date) one-quarter-ahead forecasts of S&P 500 Index capital gains and total returns using 18 economic and market variables, as follows: dividend-price ratio; price-earnings ratio; cyclically adjusted price-earnings ratio; payout ratio; Fed model; size premium; value premium; momentum premium; quarterly change in GDP, consumption, investment and CPI; 10-year Treasury note yield minus 3-month Treasury bill yield (term structure); Tobin’s q-ratio; purchasing managers index (PMI); equity allocation; federal government consumption and investment; and, a short moving average. He tests individual variables, four multivariate combinations and and six equal-weighted combinations of individual variable forecasts. He employs both conventional linear statistics and non-linear economic measures of accuracy based on sign and magnitude of forecast errors. He uses the historical mean return as a forecast benchmark. Using quarterly S&P 500 Index returns and data for the above-listed variables during January 1960 through February 2017, he finds that: Keep Reading

Which Economic Variables Really Matter for Stocks?

Which economic variables are most important for predicting stock returns? In their October 2018 paper entitled “Sparse Macro Factors”, David Rapach and Guofu Zhou apply machine learning to isolate via sparse principal component analysis (PCA) which of 120 economic variables from the FRED-MD database most influence stocks. These variables span output/income, labor market, housing, consumption, orders/inventories, money/credit, yields/exchange rates and inflation. As a preliminary step, they adjust raw economic variables by, where necessary: (1) transforming them to produce stationary series; (2) adjusting for reporting lags of one or two months. They next execute sparse PCA, which sets small component weights to zero, thereby facilitating interpretation of results without sacrificing much predictive power. For comparison, they also extract the first 10 conventional principal components from the same variables. Finally, they use 202 stock portfolios to estimate the influence of sparse and conventional principal components on the cross section of stock returns. Using monthly data for the 120 economic variables and 202 stock portfolios during February 1960 through June 2018, they find that:

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Mojena Market Timing Model

The Mojena Market Timing strategy (Mojena), developed and maintained by professor Richard Mojena, is a method for timing the broad U.S. stock market based on a combination of many monetary, fundamental, technical and sentiment indicators to predict changes in intermediate-term and long-term market trends. He adjusts the model annually to incorporate new data. Professor Mojena offers a hypothetical backtest of the timing model since 1970 and a live investing test since 1990 based on the S&P 500 Index (with dividends). To test the robustness of the strategy’s performance, we consider a sample period commencing with inception of SPDR S&P 500 (SPY) as a liquid, low-cost proxy for the S&P 500 Index. As benchmarks, we consider both buying and holding SPY (Buy-and-Hold) and trading SPY with crash protection based on the 10-month simple moving average of the S&P 500 Index (SMA10). Using the trade dates from the Mojena Market Timing live test, daily dividend-adjusted closes for SPY and daily yields for 13-week Treasury bills (T-bills) from the end of January 1993 through August 2018 (over 25 years), we find that: Keep Reading

Unemployment Claims Reports and Near-term Stock Market Returns

Each week the media report U.S. initial and continued unemployment claims (seasonally adjusted) as a potential indicator of future U.S. stock market returns. Do these indicators move the market? To investigate, we focus on weekly changes in unemployment claims during a period of “modern” information dissemination to release-day and next-week stock market returns. By modern period, we mean the history of S&P Depository Receipts (SPY), a proxy for the U.S. stock market. Using relevant news releases and archival data as available from the Department of Labor (DOL) and dividend-adjusted weekly and daily opening and closing levels for SPY during late January 1993 through mid-July 2018 (1,330 weeks), we find that:

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Chemical Activity Barometer as Stock Market Trend Indicator

A subscriber proposed: “It would be interesting to do an analysis of the Chemical Activity Barometer [CAB] to see if it has predictive value for the stock market. Either [look] at stock prices when [CAB makes] a two percent pivot down [from a preceding 6-month high] as a sell signal and one percent pivot up as a buy signal…[or when CAB falls] below its x month moving average.” The American Chemistry Council claims that CAB “determines turning points and likely future trends of the wider U.S. economy” and leads other commonly used economic indicators. To investigate its usefulness for U.S. stock market timing, we consider the two proposed strategies, plus two benchmarks, as follows:

  1. CAB SMAx Timing – hold stocks (the risk-free asset) when monthly CAB is above (below) its simple moving average (SMA). We consider SMA measurement intervals ranging from two months (SMA2) to 12 months (SMA12).
  2. CAB Pivot Timing – hold stocks (the risk-free asset) when monthly CAB most recently crosses 1% above (2% below) its maximum value over the preceding six months. We look at a few alternative pivot thresholds.
  3. Buy and Hold (B&H) – buy and hold the S&P Composite Index.
  4. Index SMA10 – hold stocks (the risk-free asset) when the S&P Composite Index is above (below) its 10-month SMA (SMA10), assuming signal execution the last month of the SMA measurement interval.

Since CAB data extends back to 1912, we use Robert Shiller’s S&P Composite Index to represent the U.S. stock market. For the risk-free rate, we use the 3-month U.S. Treasury bill (T-bill) yield since 1934. Prior to 1934, we use Shiller’s long interest rate minus 1.59% (the average 10-year term premium since 1934). We assume a constant 0.25% friction for switching between stocks and T-bills as signaled. We focus on number of switches, compound annual growth rate (CAGR) and maximum drawdown (MaxDD) as key performance metrics. Using monthly data for CAB, the S&P Composite Stock Index, estimated dividends for the stocks in this index (for calculation of total returns) and estimated long interest rate during January 1912 through December 2017 (about 106 years), and the monthly T-bill yield since January 1934, we find that: Keep Reading

Combining Market, Unemployment and Interest Rate Trends

In reaction to “Combine Market Trend and Economic Trend Signals?”, a subscriber suggested adding an interest rate trend signal to those for the U.S. stock market and U.S. unemployment rate for the purpose of timing the S&P 500 Index (SP500). To investigate, we look at combining:

We consider scenarios when the SP500 trend is positive, the UR trend is positive, the T-bill trend is positive, at least one trend is positive (>=1), at least two trends are positive (>=2) or all three trends are positive (All). For total return calculations, we adjust the SP500 monthly with estimated dividends from the Shiller dataset. When not in the index, we assume return on cash from the broker is the specified T-bill yield. We focus on gross compound annual growth rate (CAGR), maximum drawdown (MaxDD) and annual Sharpe ratio as key performance metrics. We use the average monthly T-bill yield during a year as the risk-free rate for that year in Sharpe ratio calculations. While we do not apply any stocks-cash switching frictions, we do calculate the number of switches for each scenario. Using the specified monthly data through October 2017, we find that: Keep Reading

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