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Value Investing Strategy (Strategy Overview)

Allocations for January 2021 (Final)
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Momentum Investing Strategy (Strategy Overview)

Allocations for January 2021 (Final)
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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.

Credit Spread as an Asset Return Predictor

A reader commented and asked: “A wide credit spread (the difference in yields between Treasury notes or Treasury bonds and investment grade or junk corporate bonds) indicates fear of bankruptcies or other bad events. A narrow credit spread indicates high expectations for the economy and corporate world. Does the credit spread anticipate stock market behavior?” To investigate, we define the U.S. credit spread as the difference in yields between Moody’s seasoned Baa corporate bonds and 10-year Treasury notes (T-note), which are average daily yields for these instruments by calendar month (a smoothed measurement). We use the S&P 500 Index (SP500) as a proxy for the U.S. stock market. We extend the investigation to bond market behavior via:

  • Vanguard Long-Term Treasury Investors Fund (VUSTX)
  • Vanguard Long-Term Investment-Grade Investors Fund (VWESX)
  • Vanguard High-Yield Corporate Investors Fund (VWEHX)

Using monthly Baa bond yields, T-note yields and SP500 closes starting April 1953 and monthly dividend-adjusted closes of VUSTX, VWESX and VWEHX starting May 1986, January 1980 and January 1980, respectively, all through August 2018, we find that: Keep Reading

Real Bond Returns and Inflation

A subscriber asked (more than six 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 refer to the entire series. We apply the formula used by Aswath Damodaran to the yield series to estimate the nominal T-note total returns. We use the CPI series to calculate inflation (12-month change in CPI). We subtract inflation from the T-note nominal total return to get the T-note real total return. Using annual Shiller interest rate and CPI data for 1871 through 2017, we find that: Keep Reading

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

Gold Return vs. Change in M2

A subscriber requested testing of the relationship between U.S. M2 Money Stock and gold, offered in one form via “Why Gold May Be Looking Cheap”: “[O]ne measure I’ve found useful is the ratio of the price of gold to the U.S. money supply, measured by M2, which includes cash as well as things like money market funds, savings deposits and the like. The logic is that over the long term the price of gold should move with the change in the supply of money… That equilibrium level is also relevant for future price action. When the ratio is low, defined as 25% below equilibrium, the medium 12-month return has been over 12%. Conversely, when the ratio is high, defined as 25% above equilibrium, the 12-month median return has been -6%. …This measure can be refined further. [G]old tends to trade at a higher ratio to M2 when inflation is elevated.” Because it defines specific valuation thresholds, this approach is susceptible to data snooping bias in threshold selection. We consider an alternative setup that relates monthly change in M2 to monthly gold return. We also consider the effect of inflation on this relationship. Using monthly seasonally adjusted M2 and end-of-month London gold price fix during January 1976 (to ensure a free U.S. gold market) through June 2018 (510 months), 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:

Keep Reading

ADP Employment Report and Stock Returns

Since May 2006, the ADP National Employment Report has released a monthly estimate of U.S. nonfarm private sector employment growth using actual payroll data. The report is designed “to predict private-sector employment prior to the release of the CES [Bureau of Labor Statistics’ monthly Current Employment Statistics survey] report.” Do the ADP estimates affect or predict U.S. stock market returns on the release day or over the next month? To investigate, we consider both as-released (from press releases) and as-revised ADP data (from the extended downloadable historical dataset). Using monthly ADP report release dates and as-released employment growth estimates commencing April 2006, historically modeled ADP employment growth estimates commencing April 2002 and contemporaneous daily opening/closing and monthly dividend-adjusted closing prices of SPDR S&P 500 (SPY) through early July 2018, we find that: Keep Reading

Yield Curve as a Stock Market Indicator

Conventional wisdom holds that a steep yield curve (wide U.S. Treasuries term spread) is good for stocks, while a flat/inverted curve is bad. Is this wisdom correct and exploitable? To investigate, we consider in-sample tests of the relationships between several yield curve metrics and future U.S. stock market returns and two out-of-sample signal-based tests. Using average monthly yields for 3-month Treasuries (T-bill), 1-year Treasuries, 3-year Treasuries, 5-year Treasuries and 10-year Treasuries (T-note) as available since April 1953, monthly levels of the S&P 500 Index since March 1953 and monthly dividend-adjusted levels of SPDR S&P 500 (SPY) since January 1993, all through May 2018, we find that: Keep Reading

Expert Estimates of 2018 Country Equity Risk Premiums and Risk-free Rates

What are current estimates of equity risk premiums (ERP) and risk-free rates around the world? In their April 2018 paper entitled “Market Risk Premium and Risk-free Rate Used for 59 Countries in 2018: A Survey”, Pablo Fernandez, Vitaly Pershin and Isabel Acin summarize results of a March 2018 email survey of international finance/economic professors, analysts and company managers “about the Risk Free Rate and the Market Risk Premium (MRP) used to calculate the required return to equity in different countries.” Results are in local currencies. Based on 5,173 specific and credible responses spanning 59 countries with more than five such responses, they find that: Keep Reading

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

Do Any Sector ETFs Reliably Lead or Lag the Market?

Do any of the major U.S. stock market sectors systematically lead or lag the overall market, perhaps because of some underlying business/economic cycle? To investigate, we examine the behaviors of the nine sectors defined by the Select Sector Standard & Poor’s Depository Receipts (SPDR) exchange traded funds (ETF), all of which started trading in December 1998:

Materials Select Sector SPDR (XLB)
Energy Select Sector SPDR (XLE)
Financial Select Sector SPDR (XLF)
Industrial Select Sector SPDR (XLI)
Technology Select Sector SPDR (XLK)
Consumer Staples Select Sector SPDR (XLP)
Utilities Select Sector SPDR (XLU)
Health Care Select Sector SPDR (XLV)
Consumer Discretionary Select SPDR (XLY)

Using monthly dividend-adjusted closing prices for these ETFs, along with contemporaneous data for SPDR S&P 500 (SPY) as a benchmark, during December 1998 through December 2017 (229 months), we find that: Keep Reading

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