A reader asked: “Regarding ‘Combined Value-Momentum Tactical Asset Class Allocation’, have you developed any sort of screen or model that ranks value exactly as studied in the referenced paper (asset yield or earnings yield)?”
The authors of the paper referenced in the summary you cite consider 12 asset classes: three U.S. equity classes, three international equity classes; three U.S. bond classes, two international bond classes and the risk-free rate. They describe their approach to comparing value across these 12 classes as follows:
“The starting point of our approach is to take a simple yield measure for each asset class. For equity assets we take the (trailing) earnings yield (E/P ratio), while for bond assets we take the standard yield-to-maturity. Both yield measures are adjusted for the appropriate (local) risk-free rate of return…this means that we are effectively taking the term premium as our valuation indicator.
“…we apply a limited number of asset-specific, fixed adjustments to the basic yield data. These adjustments were chosen in such a way that the main structural biases towards certain asset classes are removed. Specifically:
- for the government bond assets, US Treasuries and German and Japanese government bonds, we subtract 1% from the term premiums, which adjusts for the fact that the yield curve tends to be upward sloping;
- for US investment grade credits we subtract 2% and for US high yield bonds 6%, also to adjust for the slope of the yield curve, and additionally to adjust for default risk;
- for emerging markets equities we subtract 1% to adjust for the structurally lower P/E compared to mature equity markets;
- for US real estate equities we subtract 2% to adjust for the structurally higher yield compared to regular equities.
“…these adjustments result in [valuation] scores that are much more comparable across asset classes. In fact, after applying the adjustments, the long-term average valuation score for every asset falls in a range between -1% and +1%, which implies that structural biases towards certain asset classes are effectively eliminated.”
The authors then combine the resulting asset class valuation ranking with an asset class price momentum ranking to determine the most attractive asset classes.
While the approach appears straightforward and the data generally available, CXOadvisory.com has not developed any screens or models to implement or replicate this approach.
One could perhaps add commodity futures to the set of considered asset classes via valuation scores related to an adjusted roll yield for individual or groups of commodities.
