Equity Premium

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

Are U.S. stock and sector momentum strategies, as implemented by exchange-traded funds (ETF), attractive? To investigate, we consider five momentum-oriented U.S. equity ETFs with assets over $100 million, all currently available (in order of decreasing assets):

• iShares Edge MSCI USA Momentum Factor (MTUM) – holds U.S. large-capitalization and mid-capitalization stocks with relatively high momentum.
• First Trust Dorsey Wright Focus 5 (FV) – holds five equally weighted sector and industry ETFs selected via a proprietary relative strength methodology, reformed twice a month.
• PowerShares DWA Momentum Portfolio (PDP) – invests at least 90% of assets in approximately 100 U.S. common stocks per a proprietary methodology designed to identify powerful relative strength characteristics, reformed quarterly.
• SPDR Russell 1000 Momentum Focus (ONEO) – tracks the Russell 1000 Momentum Focused Factor Index, picking U.S. stocks that have recently outperformed.
• First Trust Dorsey Wright Dynamic Focus 5 ETF (FVC) – similar to FV but with added risk management via an increasing allocation to cash equivalents when relative strengths of more than one-third of the universe diminish relative to a cash index, reformed twice a month.

Because some sample periods are very short, we focus on daily return statistics, but also consider cumulative returns and maximum drawdowns (MaxDD). We use two benchmark ETFs, iShares Russell 1000 (IWB) and iShares Russell 3000 (IWV), according to momentum fund descriptions. Using daily returns for the five momentum funds and the two benchmarks as available through mid-September 2018, we find that: Keep Reading

A subscriber asked whether the annual equity risk premium estimates of Aswath Damodaran predict stock market returns one year ahead. The cited source offers two 58-year series of annual estimates of the U.S. equity risk premium implied by an S&P 500:

1.  Dividend Discount Model (DDM).
2.  Free Cash Flow to Equity (FCFE).

We calculate S&P 500 Index total annual returns from this source as capital gains plus dividends and then relate this total return series to each of these two implied equity risk premium series. Using the specified data during 1960 through 2017, we find that: Keep Reading

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 the effects of adding the real estate risk premium on Compound annual growth rates (CAGR) and Maximum drawdowns (MaxDD) 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 during March 1989 through August 2018 (limited by availability of earnings data), and monthly dividend-adjusted closing prices for the above asset class ETFs during July 2002 through August 2018 (194 months, limited by availability of TLT and LQD), we find that: Keep Reading

A subscriber proposed four alternative ways of timing the U.S. stock market based on simple moving averages (SMA) of the market price-earnings ratio (P/E), as follows:

1. 5-Year Binary – hold stocks (cash) when P/E is below (above) its 5-year SMA.
2. 10-Year Binary – hold stocks (cash) when P/E is below (above) its 10-year SMA.
3. 15-Year Binary – hold stocks (cash) when P/E is below (above) its 15-year SMA.
4. 5-Year Scaled – hold 100% stocks (cash) when P/E is five or more units below (above) its 5-year SMA. Between these levels, scale allocations linearly.

To obtain a sample long enough for testing these rules, we use the monthly U.S. data of Robert Shiller. While offering a very long history, this source has the disadvantage of blurring monthly data as averages of daily values. How well do these alternative timing strategies work for this dataset? Using monthly data for the S&P Composite Index, annual dividends, annual P/E and 10-year government bond yield since January 1871 and monthly 3-month U.S. Treasury bill (T-bill) yield as return on cash since January 1934, all through August 2018, we find that: Keep Reading

Is there a best way for investors to measure firm profitability for global stock selection? In their August 2018 paper entitled “Constructing a Powerful Profitability Factor: International Evidence”, Matthias Hanauer and Daniel Huber investigate which measure of firm profitability best predicts associated stock returns. They consider six measures: return on equity; gross profitability; operating profitability calculated in two ways; cash-based operating profitability (excluding accruals); and, cash-based gross profitability (also excluding accruals). They construct a long-short profitability factor for each measure and test its power to predict stock returns both standalone and in combination with other kinds of factors (market, size, book-to-market, momentum, investment and accruals) and the other profitability factors. Using monthly returns and annual accounting data for non-financial common stocks in 49 countries (excluding the U.S.) during July 1989 through June 2016, they find that: Keep Reading

How, and how well, do institutional equity traders manage global stock trading frictions? In the April 2018 draft of their paper entitled “Trading Costs”, Andrea Frazzini, Ronen Israel and Tobias Moskowitz examine the real-world trading frictions of a large trader. They define trading frictions as the difference in results between a theoretical portfolio with zero frictions and a practical tracking portfolio with frictions. They account for all components of trading frictions: broker commissions, bid-ask spreads and price impacts of trading. They record market price at trade initiation, volume traded and execution price for each share traded, as well as type of trade (buy long, buy-to-cover, sell long or sell short). They describe how frictions vary by trade type, stock characteristics, trade size, time and exchange. Based on preliminary findings, they devise and test out-of-sample a price impact model based on market conditions, stock characteristics and trade size calibrated to actual U.S. and international trades. Using $1.7 trillion of orders and trade execution data from a large institutional money manager spanning 21 developed equity markets during August 1998 through June 2016, they find that: Keep Reading

Is the level, or changes in the level, of Federal Reserve (Fed) holdings of U.S. Treasuries (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 August 2018, we find that: Keep Reading

Do stock dividends exhibit exploitable risk premiums? In their July 2018 paper entitled “A Model-Free Term Structure of U.S. Dividend Premiums”, Maxim Ulrich, Stephan Florig and Christian Wuchte construct a term structure of the dividend risk premium and test strategies to time this premium at specific horizons. They specify dividend risk premium as the spread between:

• Expected dividend growth rate based on analyst 1-year and 2-year S&P 500 dividend forecasts, extended by analyst 5-year earnings growth estimates assuming constant future payout ratio.
• Expected dividend growth rate derived from equity index put and call option prices across different maturities.

They model an S&P 500 dividend capture portfolio for a given horizon as: long an S&P 500 Index put option of maturity matching the horizon; short an index call option of same maturity and strike price; long the index; and, short the money market in an amount matched to the option strike price. They test two strategies for capturing this premium at a 12-month horizon: (1) each month (last trading day) reform and hold the dividend capture portfolio; or, (2) each month reform and hold the dividend capture portfolio only when the dividend risk premium is positive (analyst-estimated dividends are higher than options-implied dividends). They model the risk-free rate/money market rate across horizons using the U.S. Dollar Overnight Index Swap rate for one day to 10 years. For the S&P 500 Index, they assume annual expense ratio 0.07% and 0.01% average bid-ask spread. For options, they estimate trading frictions with actual bid-ask spreads. Using S&P 500 Index/options and analyst forecast data as specified during January 2004 through October 2017, they find that:

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From a purely statistical perspective, how many factors are optimal for explaining both time series and cross-sectional variations in stock anomaly/stock returns, and how do these statistical factors relate to stock/firm characteristics? In their July 2018 paper entitled “Factors That Fit the Time Series and Cross-Section of Stock Returns”, Martin Lettau and Markus Pelger search for the optimal set of equity factors via a generalized Principal Component Analysis (PCA) that includes a penalty on return prediction errors returns. They apply this approach to three datasets:

1. Monthly returns during July 1963 through December 2017 for two sets of 25 portfolios formed by double sorting into fifths (quintiles) first on size and then on either accruals or short-term reversal.
2. Monthly returns during July 1963 through December 2017 for 370 portfolios formed by sorting into tenths (deciles) for each of 37 stock/firm characteristics.
3. Monthly excess returns for 270 individual stocks that are at some time components of the S&P 500 Index during January 1972 through December 2014.

They compare performance of their generalized PCA to that of conventional PCA. Using the specified datasets, they find that: Keep Reading