Fundamental Valuation

To determine whether the stock market is expensive or cheap, some experts use aggregate valuation ratios, either trailing or forward-looking, such as earnings-price ratio (E/P) and dividend yield. Under belief that such ratios are mean-reverting, most imminently due to movement of stock prices, these experts expect high (low) future stock market returns when these ratios are high (low). Where are the ratios now and how are they changing during recent months? Using recent actual and forecasted earnings and dividend data from Standard & Poor’s and associated S&P 500 Index levels, we find that: Keep Reading

Leading index providers have introduced thematic stock indexes to address transformative macroeconomic, geopolitical or technological trends (for example, cybersecurity, robotics, autonomous vehicles and clean power). How do these indexes relate to standard asset pricing models? In his August 2021 paper entitled “Betting Against Quant: Examining the Factor Exposures of Thematic Indices”, David Blitz examines the performance characteristics of these indexes based on widely used factor models of stock returns and discusses why investors may follow these indexes via exchange-traded funds (ETF) despite unfavorable factor exposures. He considers 36 S&P indexes (narrower, equal-weighted) and 12 MSCI indexes (broader, capitalization-weighted) with at least three years of history. Using monthly returns for these 48 indexes and for components of the Fama-French 5-factor (market, size, book-to-market, profitability and investment) model and the momentum factor as available during June 2013 through April 2021, he finds that:

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In response to the U.S. stock market timing backtest in “Usefulness of P/E10 as Stock Market Return Predictor”, a subscriber suggested combining a 10-month simple moving average (SMA10) technical signal with a P/E10 (or Cyclically Adjusted Price-Earnings ratio, CAPE) fundamental signal. Specifically, we test:

• SMA10 – bullish/in stocks (bearish/in government bonds) when prior-month stock index level is above (below) its SMA10.
• SMA10 AND Binary 20-year Bond – in stocks only when both SMA10 and P/E10 Binary 20-year signals are bullish, and otherwise in bonds. The latter rule is bullish when last-month P/E10 is below its rolling 20-year monthly average.
• SMA10 OR Binary 20-year Bond – in stocks when one or both of the two signals are bullish, and otherwise in bonds.
• NEITHER SMA10 NOR Binary 20-year Bond – in stocks only when neither signal is bullish, and otherwise in bonds.

We use Robert Shiller’s S&P Composite Index to represent stocks. We estimate monthly levels of a simple 10-year government bond index and associated monthly returns using Shiller yield data as described in “Usefulness of P/E10 as Stock Market Return Predictor”. We consider buying and holding the S&P Composite Index and the P/E10 Binary 20-year Bond strategy as benchmarks. Using monthly data from Robert Shiller, including S&P Composite Index level, associated dividends, 10-year government bond yields and values of P/E10 as available during January 1871 through June 2021, we find that:

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In response to the U.S. stock market timing backtest in “Usefulness of P/E10 as Stock Market Return Predictor”, a subscriber suggested a modification for exploiting P/E10 (or Cyclically Adjusted Price-Earnings ratio, CAPE). Instead of binary signals that buy (sell) stocks when P/E10 crosses below (above) its historical average, employ a scaled allocation to stocks that considers how far P/E10 is from average. Specifically:

• If P/E10 is more than 2 standard deviations below its past average, allocate 100% to the S&P Composite Index.
• If P/E10 is more than 2 standard deviations above its past average, allocate 0% to the S&P Composite Index.
• If P/E10 is between these thresholds, allocate a percentage (ranging from 100% to 0%) to the S&P Composite Index, scaled linearly.

To investigate, we backtest this set of rules. Using monthly data from Robert Shiller, including S&P Composite Index level, associated dividends, 10-year government bond yields and values of P/E10 as available during January 1871 through December 2019, we find that:

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Does P/E10 (or Cyclically Adjusted Price-Earnings ratio, CAPE) usefully predict U.S. stock market returns? Per Robert Shiller’s data, P/E10 is inflation-adjusted S&P Composite Index level divided by average monthly inflation-adjusted 12-month trailing earnings of index companies over the last ten years. To investigate its usefulness, we consider in-sample regression/ranking tests and out-of-sample cumulative performance tests. Using monthly values of P/E10, S&P Composite Index levels (calculated as average of daily closes during the month), associated dividends (smoothed), 12-month trailing real earnings (smoothed) and interest rates as available during January 1871 through June 2021, we find that: Keep Reading

Are stock quality strategies, as implemented by exchange-traded funds (ETF), attractive? To investigate, we consider five ETFs, all currently available (from oldest to youngest):

• Invesco S&P 500 Quality ETF (SPHQ) – seeks to track performance of S&P 500 stocks with the highest quality scores based on firm return on equity, accruals ratio and financial leverage ratio, reformed semi-annually. The benchmark is SPDR S&P 500 (SPY).
• iShares Edge MSCI USA Quality Factor ETF (QUAL) – seeks to track performance of U.S. large-capitalization and mid-capitalization stocks selected based return on firm equity, earnings variability and debt-to-equity. The benchmark is SPY.
• iShares Edge MSCI Intl Quality Factor ETF (IQLT) – seeks to track performance of large-capitalization and mid-capitalization developed international stocks screened for attractive return-on-equity, earnings variability and debt-to-equity. The benchmark is iShares MSCI ACWI ex U.S. ETF (ACWX).
• Fidelity Quality Factor ETF (FQAL) – seeks to track performance of U.S. large-capitalization and mid-capitalization stocks with a higher firm quality profile than the broader market. The benchmark is Vanguard Russell 1000 Index Fund ETF (VONE).
• Vanguard U.S. Quality Factor ETF (VFQY) – applies a rules-based quantitative model to select U.S. common stocks with strong fundamentals (strong profitability and healthy balance sheets) across market capitalizations, sectors and industry groups. The benchmark is iShares Russell 3000 ETF (IWV).

We calculate monthly return statistics, along with compound annual growth rates (CAGR) and maximum drawdowns (MaxDD). Using monthly returns for the stock quality ETFs and benchmarks as available through June 2021, we find that:

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Can machine learning-generated stock market crash predictions be amenable to human interpretation? In their June 2021 paper entitled “Explainable AI (XAI) Models Applied to Planning in Financial Markets”, Eric Benhamou, Jean-Jacques Ohana, David Saltiel and Beatrice Guez apply a gradient boosting decision tree (GBDT) to 150 technical, fundamental and macroeconomic inputs to generate daily predictions of short-term S&P 500 Index crashes. They define a crash as a 15-day S&P 500 Index return below its historical fifth percentile within the training dataset. The 150 model inputs encompass:

1. Risk aversion metrics such as asset class implied volatilities and credit spreads.
2. Price indicators such as returns, major stock index Sharpe ratios, distance from a long-term moving average and and equity-bond correlations.
3. Financial metrics such as 12-month sales growth and price-to-earnings ratio forecasts.
4. Macroeconomic indicators such Citigroup regional and global economic surprise indexes.
5. Technical indicators such as market breath and index put-call ratio.
6. Interest rates such as 10-year and 2-year U.S. Treasury yields and break-even inflation level.

They first rank and filter the 150 inputs based on GBDT to discard about two thirds of the variables. They then apply the Shapley value solution concept to identify the most important of the remaining variables and thereby support interpretation of methodology outputs. Using daily values of the 150 model inputs and daily S&P 500 Index roll-adjusted futures prices from the beginning of January 2003 through mid-January 2021 (with data up to January 2019 used for training, the next year for validation and the rest for testing), they find that:

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How do investors react to different kinds of firm-level environmental, social and governance (ESG) news? In their April 2021 paper entitled “Which Corporate ESG News does the Market React to?”, George Serafeim and Aaron Yoon examine stock returns around ESG news from analysts, media, advocacy groups and government regulators (but not firms themselves) as compiled/evaluated by TruValue Labs. Evaluation includes degree to which each news item is positive or negative. They segment the news sample based on materiality classifications from the Sustainability Accounting Standards Board (SASB). Using daily market-adjusted and industry-adjusted stock returns associated with 111,020 firm-day ESG news items spanning 3,126 companies during January 2010 through June 2018, they find that: Keep Reading

Will equity funds “managed” by artificial intelligence (AI) outperform human investors? To investigate, we consider the performance of AI Powered Equity ETF (AIEQ), which “seeks long-term capital appreciation within risk constraints commensurate with broad market US equity indices.” Per the offeror, the EquBot model supporting AIEQ: “…leverages IBM’s Watson AI to conduct an objective, fundamental analysis of U.S.-listed common stocks and real estate investment trusts…based on up to ten years of historical data and apply that analysis to recent economic and news data. Each day, the EquBot Model…identifies approximately 30 to 125 companies with the greatest potential over the next twelve months for appreciation and their corresponding weights… The EquBot model limits the weight of any individual company to 10%. At times, a significant portion of the Fund’s assets may consist of cash and cash equivalents.” We use SPDR S&P 500 (SPY) as a simple benchmark for AIEQ performance. Using daily and monthly dividend-adjusted closes of AIEQ and SPY from AIEQ inception (October 18, 2017) through April 2021, we find that: Keep Reading

How does the U.S. stock market earnings yield (inverse of price-to-earnings ratio, or E/P) interact with the U.S. inflation rate over the long run? Is any such interaction exploitable? To investigate, we employ the long run dataset of Robert Shiller. Using monthly data for the S&P Composite Stock Index, estimated aggregate trailing 12-month earnings and dividends for the stocks in this index, and estimated U.S. Consumer Price Index (CPI) during January 1871 through February 2021 (over 150 years), and estimated monthly yield on 1-year U.S. Treasury bills (T-bills) since January 1951, we find that:

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