Is there a way to suppress the volatility and drawdowns of a mixed value and momentum stock strategy while retaining most of its benefit? In his September 2015 paper entitled “Learning to Play Offense and Defense: Combining Value and Momentum from the Bottom up, and the Top Down”, Mebane Faber examines the feasibility of a strategy that combines market valuation and market trend timing (defense) with a mixed value and momentum stock selection strategy (offense). Specifically:

For offense, he each month: (1) ranks stocks by each of price-to-earnings, price-to-book and earnings before interest and taxes-to-total enterprise value ratios and then re-ranks them by the average of the three separate value rankings; (2) ranks stocks by each of 3-month, 6-month and 12-month past returns and then re-ranks them by the average of the three separate momentum rankings; and, (3) forms an equally weighted portfolio of the top 100 value and top 100 momentum stocks and holds for three months (three overlapping portfolios).

For defense, he each month: (1) hedges half of the portfolio by shorting the S&P 500 Index if the long-term real earnings yield for the S&P 500 (inverse of the Cyclically Adjusted Price-Earnings ratio, CAPE or P/E10 as calculated by Robert Shiller, minus the most recently available actual 12-month U.S. inflation rate) is in the 20% of its lowest inception-to-date monthly values; and, (2) hedges half of the portfolio by shorting the S&P 500 Index if the index is below its 12-month simple moving average.

The overall portfolio can therefore be 100% long “offense” stocks, 50% hedged or market neutral. He does not account for costs of portfolio reformations or hedging. Using monthly total returns for all NYSE stocks in the top 60% of market capitalizations, monthly levels of the S&P 500 Total Return Index and monthly values of CAPE during 1964 through 2014, *he finds that:* Keep Reading