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Equity Premium

Governments are largely insulated from market forces. Companies are not. Investments in stocks therefore carry substantial risk in comparison with holdings of government bonds, notes or bills. The marketplace presumably rewards risk with extra return. How much of a return premium should investors in equities expect? These blog entries examine the equity risk premium as a return benchmark for equity investors.

Equity Factors Come and Go with Economic Regimes?

Are many accepted equity factors/return anomalies artifacts of the secular decline in interest rates during their discovery sample periods? In their September 2022 paper entitled “The Factor Multiverse: The Role of Interest Rates in Factor Discovery”, Jules van Binsbergen, Liang Ma and Michael Schwert study the role of the secular decline in interest rates since the early 1980s in the discovery of equity factors/return anomalies. They use value-weighted long-short portfolios and monthly reformation for all factors/anomalies. They apply duration-matched fixed income portfolio return adjustments to returns for each anomaly portfolio to model returns for the latter if there had been no interest rate decline. They then classify each anomaly as false positive (present for unadjusted returns, but not adjusted returns), false negative (present for adjusted returns, but not unadjusted returns) or robust to the effect of interest rates (present for both unadjusted and adjusted returns). Using monthly returns for 153 accepted factors/anomalies over respective original test periods and for 1,395 potential undiscovered factors/anomalies based on firm accounting variables during July 1962 through December 2020, along with contemporaneous yield data for zero coupon U.S. Treasury bonds and notes, they find that:

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VIX and Future Stock Market Returns

Market commentators sometimes cite a high Chicago Board Options Exchange (CBOE) Volatility Index (VIX), the options-implied volatility of the S&P 500 Index as an indicator of investor sentiment and therefore a contrarian signal for the stock market. Specifically, a relatively high (low) VIX indicates panic (complacency) and therefore pending stock market strength (weakness). Does evidence support such conventional wisdom? To check, we relate the level of VIX to S&P 500 Index returns over the next 5, 10, 21, 63 and 126 trading days. Using daily closes for VIX and the S&P 500 Index during January 1990 (limited by the VIX series) through September 2022, we find that: Keep Reading

Effects of Firm ESG Rating Changes on Stock Returns

Is growing interest in environmental, social, and governance (ESG) issues among investors and asset managers materially affecting stock selection decisions and associated returns? In the September 2022 version of their paper entitled “The Economic Impact of ESG Ratings”, Florian Berg, Florian Heeb and Julian Kölbel measure impacts of ESG rating changes on associated mutual fund holdings and stock returns. They focus on average abnormal holdings changes and average cumulative abnormal returns from: (1) 12 months before rating change up to the change, and (2) from the ratings change through 24 months after the change. Abnormal returns control for firm leverage, size, book-to-market ratio and profitability, and for stock return beta and momentum. Using quarterly fundamentals and monthly stock returns and ESG-dedicated mutual fund holdings for 3,665 firms with a total of 2,545  MSCI ESG rating upgrades and 2,133 downgrades during February 2013 through September 2020, they find that:

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Aggregated Firm ESG Ratings and Future Stock Market Returns

Do environmental, social, and corporate governance (ESG) ratings aggregated across individual firms predict overall stock market returns? In the July 2022 version of their paper entitled “ESG and the Market Return”, Ran Chang, Liya Chu, Bohui Zhang, Guofu Zhou and Jun Tu investigate whether ESG ratings in aggregate predict overall stock market returns. Specifically, they each month:

  • Combine 38 firm-level ESG subcategory ratings via equal weighting to calculate 38 market-level ESG measures.
  • Apply machine learning tools to these market-level measures to suppress noise and redundancies and generate 14 market-level predictors.
  • Aggregate the 14 predictors into a market-level composite ESG index, and similarly develop market-level environmental, social and governance ESG subindexes.
  • Use full-sample (in-sample) regression to relate ESG index/subindexes to next-month and next-year stock market excess return (value-weighted stock market return minus U.S. Treasury bill yield).
  • Use the first seven years of the sample as the initial training period and the rest of the data as an out-of-sample forecast evaluation period.

Using monthly firm ESG data from Morningstar Sustainalytics and stock market excess returns during August 2009 (ESG measurement inception) through September 2019, they find that: Keep Reading

Expected Real T-note Gap and Future Asset Returns

Is the gap between the yield on the 10-year constant maturity U.S. Treasury note (T-note) and the 10-Year breakeven inflation rate (a measure of expected inflation over the next 10 years derived from T-note yield and 10-Year Treasury inflation-indexed constant maturity securities yield) indicative of future stock market or U.S. Treasury bond yields? To investigate, we relate monthly values of this gap (the expected real T-note gap) and changes in the gap to future monthly returns for SPDR S&P 500 ETF Trust (SPY) and iShares 20+ Year Treasury Bond ETF (TLT). Using monthly values for the four series during January 2003, limited by the breakeven inflation rate series, through July 2022, we find that: Keep Reading

Best Model of Future Stock Market Returns?

Which variables deserve greatest focus when predicting stock market returns? In their July 2022 paper entitled “Searching for the Best Conditional Equity Premium Model”, Hui Guo, Saidat Sanni and Yan Yu exhaustively explore combinations of 18 previously identified potential stock market return predictors to isolate the most powerful subset. They focus on a best subset selection method with a penalty on complexity, thereby suppressing data snooping bias and selecting a manageable subset. For robustness, they consider four alternative variable selection methods. Using quarterly U.S. data for these 18 variables and S&P 500 Index levels/returns during 1947 through 2020, they find that: Keep Reading

Currency Crashes and Future Stock Market Returns

A subscriber asked whether a rapid, large (20% or more) individual country currency devaluation versus the U.S. dollar indicates that the country’s stock market will rise the next quarter (with country exports presumably more competitive post-devaluation). To investigate, we select five currency exchange rates versus the U.S. dollar and relate monthly and quarterly changes in these rates to next-month and next-quarter total returns in U.S. dollars on exchange-traded funds (ETF) for respective country stock markets, as follows:

  1. Malaysia: Ringgit to U.S. Dollar and iShares MSCI Malaysia ETF (EWM).
  2. South Korea: Won to U.S. Dollar and iShares MSCI South Korea ETF (EWY).
  3. Brazil: Real to U.S. Dollar and iShares MSCI Brazil ETF (EWZ).
  4. China: Yuan Renminbi to U.S. Dollar and SPDR S&P China ETF (GXC).
  5. India: Rupee to U.S. Dollar and iShares India 50 ETF (INDY).

We consider both linear relationships and outlier relationships (> 20% devaluations). Using monthly and quarterly changes/dividend-adjusted returns for the selected currency/equity ETF pairs as available (all limited by ETF histories) through June 2022, we find that: Keep Reading

Failure of Equity Multifactor Funds?

Multifactor funds offer rules-based, diversified exposures to firm/stock factors found to beat the market in academic studies. Do the funds beat the market in real life? In his June 2022 paper entitled “Multifactor Funds: An Early (Bearish) Assessment”, Javier Estrada assesses performance of such funds across U.S., global and emerging markets relative to that of corresponding broad capitalization-weighted indexes and associated exchange-traded funds (ETF). He focuses on multifactor funds with exposure to at least three factors that are explicitly marketed as multifactor funds. Using monthly total returns for 56 U.S.-based equity multifactor funds with at least three years of data and $10 million in assets from respective inceptions (earliest June 2014) through March 2022, and total returns for matched broad market indexes and ETFs, he finds that:

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High-yield Bond Spread and Stock Market Returns

A subscriber asked about the relationship between the high-yield bond spread and stock market return, with focus on when the latter is entering a bear market. To investigate, we use the ICE BofA US High Yield Index Option-Adjusted Spread (HY Spread) as a proxy for the high-yield bond spread and SPDR S&P 500 ETF Trust (SPY) as a proxy for the U.S. stock market. We look at the following interactions between HY Spread and SPY:

  • Daily lead-lag correlations between HY Spread/change in HY Spread and SPY return.
  • Monthly lead-lag correlations between HY Spread/change in HY Spread and SPY return.
  • Average next-month SPY return by range of monthly changes in HY Spread.
  • Monthly changes in HY Spread before the worst next-month SPY returns.
  • Next-month SPY returns after the biggest monthly jumps in HY Spread.

Using daily values of HY Spread and daily dividend-adjust SPY prices from the end of December 1996 (limited by HY Spread) through mid-June 2022, we find that: Keep Reading

Exploiting S&P 500 Index Additions and Deletions

Can investors beat the market by exploiting preannounced (anti-value) changes to traditional capitalization-weighted indexes, generally comprised of additions with recent strong performance and deletions with recent weak performance? In their May 2022 paper entitled “The Avoidable Costs of Index Rebalancing”, Robert Arnott, Chris Brightman, Vitali Kalesnik and Lillian Wu examine ways to exploit any momentum and/or reversion in these potentially overvalued additions and undervalued deletions. They focus on the period since October 1989, when S&P began preannouncing (announcement date) changes to the index days or weeks before the effective date of the changes (trade date). They further focus on discretionary changes, distinct from those driven by spinoffs and divestitures (nondiscretionary additions) or bankruptcies and mergers (nondiscretionary deletions). They note that changes in index holdings were made at the market close on the effective date until February 2017, and the prior close thereafter. Using data for 663 S&P 500 Index additions and 299 discretionary deletions during October 1989 through June 2021, they find that:

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