Economic Indicators

Do changes in the U.S. federal regulatory burden predict U.S. stock market returns? To check, we consider two measures of the regulatory burden:

1. Annual number of pages in the Federal Register (FR) during 1936-2016 – “…in which all newly proposed rules are published along with final rules, executive orders, and other agency notices—provides a sense of the flow of new regulations issued during a given period and suggests how the regulatory burden will grow as Americans try to comply with the new mandates.”
2. Annual number of pages in the Code of Federal Regulations (CFR) during 1975-2016 – “…the codification of all rules and regulations promulgated by federal agencies. Its size…provides a sense of the scope of existing regulations with which American businesses, workers, and consumers must comply.

Specifically, we relate annual changes in these measures to annual returns for the S&P 500 Index. Using the specified regulatory data and annual S&P 500 Index total returns during 1929 through 2016, we find that: Keep Reading

Do hedge funds demonstrate the exploitability of real-time economic data? In their June 2017 paper entitled “Can Hedge Funds Time the Market?”, Michael Brandt, Federico Nucera and Giorgio Valente evaluate whether all or some equity hedge funds vary equity market exposure in response to real-time economic data, and (if so) whether doing so improves their performance. Their proxy for real-time economic data available to a sophisticated investor is the 20-day moving average of an economic growth index derived from principal component analysis of purely as-released industrial output, employment and economic sentiment. They relate this data to hedge fund performance by:

1. Applying a linear regression to measure the sensitivity (economic data beta) of each hedge fund to monthly changes in economic data.
2. Sorting funds into tenths (deciles) based on economic data beta and calculating average next-month equally weighted risk-adjusted performance (7-factor alpha) by decile. The seven monthly factors used for risk adjustment are: equity market excess return; equity size factor; change in 10-year U.S. Treasury note (T-note) yield; change in yield spread between BAA bonds and T-notes; and trend following factor for bonds, currencies and commodities.

Using sample of 2,224 dead and alive equity hedge funds having at least 36 months of net-of-fee returns and average assets under management of at least $10 million, and contemporaneous daily values of the economic growth index, during January 1994 through December 2014, they find that:

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Is there a straightforward way to interpret the state of the yield curve as a manifestation of how efficiently the economy is processing information? In his March 2017 paper entitled “Simple New Method to Predict Bear Markets (The Entropic Linkage between Equity and Bond Market Dynamics)”, Edgar Parker Jr. presents and tests a way to understand interaction between bond and equity markets based on arrival and consumption of economic information. He employs Shannon entropy to model the economy’s implied information processing ratio (R/C), with interpretations as follows:

1. R/C ≈ 1: healthy continuously upward-sloping yield curve when information arrival and consumption rates are approximately equal.
2. R/C >> 1: low end of the yield curve inverts when information is arriving much faster than it can be consumed.
3. R/C << 1: high end of the yield curve inverts when information is arriving much slower than it can be consumed.

Under the latter two conditions, massive information loss (entropy growth) occurs, and firms cannot confidently plan. These conditions delay/depress economic growth and produce equity bear markets. He tests this approach by matching actual yield curve data with standardized (normal) R and C distributions that both have zero mean and standard deviation one (such that standardized R and C may be negative). Using daily yields for U.S. Treasuries across durations and daily S&P 500 Index levels during 1990 through 2016, he finds that: Keep Reading

What is “under the hood” at quantitative investment firms? In their December 2016 book-length paper entitled “Factor Investing and Asset Allocation: A Business Cycle Perspective”, Vasant Naik, Mukundan Devarajan, Andrew Nowobilski, Sebastien Page and Niels Pedersen examine the process of translating macroeconomic forecasts into alpha-generating portfolios via mean-variance optimization. They address how to: (1) specify the risk factors driving returns in global financial markets; (2) estimate factor returns and volatilities; and, (3) construct an optimal portfolio of factors. They emphasize the primacy of the business cycle in estimating future returns and volatilities of risk factors across multiple asset classes. They also emphasize the importance of market valuations (to identify when price fluctuations create tactical opportunities) in investment decision making. Based on the body of financial markets research over the last 50 years and their own experiences with the investment process, they conclude that: Keep Reading

Do supply chain (trade network) dynamics explain intermediate-term momentum in industry stock returns? In their December 2016 paper entitled “Feedback Loops in Industry Trade Networks and the Term Structure of Momentum Profits”, Ali Sharifkhani and Mikhail Simutin examine whether industry trading network activities create feedback that induces intermediate-term autocorrelation (echo) in associated stock returns. They apply graph theory to quantify supply-demand relationships within industry trade networks and strength of feedback loops that connect each of 49 industries to itself. They then relate network feedback strength to intermediate-term momentum (industry return from 12 months ago to seven months ago) and short-term momentum (industry return from six months ago to two months ago) for each industry as follows:

1. Each month, sort the 49 industries into thirds (terciles) by current trade network feedback strength.
2. Calculate the value-weighted average return of stocks within each industry.
3. Within each feedback strength tercile, form a hedge portfolio that is long (short) the equal-weighted fifth, or quintile, of industries with the highest (lowest) past returns over each of the two specified momentum measurement intervals.
4. Calculate average next-month return for each feedback strength-momentum double-sorted hedge portfolio.

Using industry input-output network trade data as issued (partly every five years and partly annual) and monthly industry component stock returns/capitalizations for 49 U.S. industries since 1972, and related analyst coverage data since 1984, all through December 2014, they find that: Keep Reading

Do specific stocks react differently to economic uncertainty? In their December 2016 paper entitled “Is Economic Uncertainty Priced in the Cross-Section of Stock Returns?”, Turan Bali, Stephen Brown and Yi Tang investigate the role of economic uncertainty in the cross-sectional pricing of individual stocks. They measure economic uncertainty monthly as an aggregation of the volatilities of the unpredictable components of a large number of economic indicators (see the chart below). They then calculate each stock’s sensitivity to economic uncertainty by regressing next-month returns versus economic uncertainty over rolling 60-month windows. Finally, sort stocks into tenths (deciles) by economic uncertainty regression betas and measure economic uncertainty factor returns as the difference in next-month average returns of stocks in extreme deciles. They test robustness via multiple factor models of stock returns and many control variables. Using monthly economic uncertain index data, monthly returns for a broad sample of U.S. stocks and monthly values of control variables during July 1972 through December 2014, they find that: Keep Reading

Do changes in the dollar-euro exchange rate reliably interact with the U.S. stock market and gold? For example, do declines in the dollar relative to the euro indicate increases in the dollar value of hard assets? Are the interactions coincident or exploitably predictive? To investigate, we relate changes in the dollar-euro exchange rate to returns for U.S. stock indexes and spot gold. Using end-of-month and end-of-week values of the dollar-euro exchange rate, levels of the S&P 500 Index and Russell 2000 Index and spot prices for gold during January 1999 (limited by the exchange rate series) through October 2016, we find that: Keep Reading

Does the stock market perform poorly in a deflationary environment? In the September 2016 version of his paper entitled “Deflation and Stock Prices”, Michael Clemens explores relationships between change in the Consumer Price Index (CPI) and each of stock market return and stock market valuation. He defines four deflation/inflation regimes based on ranges of annualized average monthly change in CPI over the previous 12 months. He considers both contemporaneous (last 12 months) and future (next 12 months) stock market returns. He measures stock market price-earnings ratio (P/E) as the average of Robert Shiller’s Cyclically Adjusted Price-Earnings Ratio (CAPE or P/E10), 12-month historical P/E and 12-month future P/E known with perfect foresight. Using Shiller’s U.S. monthly data spanning January 1871 through February 2016 and shorter, recent samples for Japan (January 2001 through February 2016) and Switzerland (January 2005 through February 2016), he finds that: Keep Reading

How do the long and short sides of futures trend-following strategies differently affect portfolio riskiness? In their September 2016 paper entitled “The Long and Short of Trend Followers”, Jarkko Peltomaki, Joakim Agerback and Tor Gudmundsen-Sinclair investigate via linear regression behaviors of the long and short sides of commonly used trend-following strategies across equities, bonds, commodities and currency futures/forwards under different economic conditions. They model trend-following performance by combining two sets of rules: (1) four slow-reacting simple moving average pair crossover rules using 75-225, 100-300, 125-375 or 150-450 daily moving average pairs; and, (2) four fast-reacting moving average breakout rules based on fluctuations around a long-term moving average. They apply the same allocation method for all rules to set a constant initial risk per trade, adjusted daily by scaling inversely with volatility. They examine how long and short trend-following returns depend on economic environment, focusing on interest rates. They assume trading frictions total $30 per contract. Using futures contract data for 22 equity indexes, 15 government bonds, 17 commodities and six currencies relative to the U.S. dollar, and contemporaneous Commodity Trading Advisor (CTA) performance indexes, during 1984 through 2015, they find that: Keep Reading

Is global diversification within asset classes disappearing as worldwide economic and financial integration increases? In their August 2016 paper entitled “Globalization and Asset Returns”, Geert Bekaert, Campbell Harvey, Andrea Kiguel and Xiaozheng Wang examine whether economic and financial integration increases global comovement of country equity, bond and currency exchange market returns. They examine three measures of return comovement for each asset class: average pairwise correlation, average beta relative to the world market and average idiosyncratic volatility. They apply these measures separately to developed markets and emerging markets. Using monthly equity, bond and currency exchange market returns in U.S. dollars for 26 developed markets and 32 emerging markets as available from various inceptions through December 2014, they find that: Keep Reading