Equity Premium

Do equity premium predictors published in the past still work after extending their respective discovery samples through 2020? In their September 2021 paper entitled “A Comprehensive Look at the Empirical Performance of Equity Premium Prediction II”, Amit Goyal, Ivo Welch and Athanasse Zafirov reexamine the power of 29 variables found to predict the equity premium (stock market return minus U.S. Treasury bill yield) in 26 prominent published papers, with data samples ending between 2000 and 2017, by extending these samples through 2020. They test not only their predictive powers, but also their performances when applied to four simple market timing strategies with Treasury bills as the alternative asset:

1. Untilted, Unscaled – go long the equity premium when the predictor is above its historical median and short otherwise.
2. Tilted, Unscaled – go long the equity premium unless the predictor is below its historical 25th percentile.
3. Untilted, Z-scaled – first calculate a Z-score by subtracting the historical median from the current value and dividing by the historical standard deviation, and then scale the equity premium allocation by the Z-score.
4. Tilted, Z-scaled – first calculate a Z-score by subtracting the historical 25th percentile value from the current value and dividing by the historical standard deviation, and then scale the equity premium allocation by the Z-score.

The benchmark for these strategies is buying and holding the equity premium. Extending the original discovery sample for each of the 29 predictors through December 2020 (typically about 10 years additional data), they find that: Keep Reading

Do credit portfolio managers adjust their portfolios more expeditiously than equity managers, thereby offering a means to time the equity market? In his August 2021 paper entitled “Credit-Informed Tactical Asset Allocation – 10 Years On”, David Klein updates and enhances the strategy presented in his paper of June 2011 (see “Credit as a Tactical Asset Allocation Signal”). The strategy holds stocks (short-term Treasuries) when stocks appear undervalued (overvalued) relative to corporate bonds based on data from a rolling 6-month historical interval. His proxy for corporate bonds is the ICE BofA Single-B US High Yield Index Option-Adjusted Spread (converted to a default probability) and for stocks is the Russell 2000 Index (with dividends). He hypothesizes that stock prices tend to fall when credit spread widens, and small capitalization stocks are more sensitive to credit conditions than large capitalization stocks. Two enhancements to the original strategy are: (1) shorten the lookback from six to three months; and (2) increase the equity allocation by adding a premium to equity values. A third enhancement is taking a 120% long position in stocks when they are undervalued and a 20% short position in stocks when they are overvalued (with 2% estimated annual costs for implementation). Updating and enhancing this strategy with 10 years of new daily data through June 2021, he finds that:

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Is it possible to isolate environmental, social and governance characteristics (ESG) effects on stock returns from those of other stock characteristics? In their July 2021 paper entitled “Chasing The ESG Factor”, Abraham Lioui and Andrea Tarelli specify a cross-sectional long-short ESG factor that neutralizes exposures to other firm characteristics, such as size and book-to-market ratio. By creating a pure ESG factor, they are able to isolate ESG alpha and estimate its separate E, S and G contributions. Their approach also suppresses effects of arbitrary ESG rating scales. They further construct an ESG sentiment index based on media attention to ESG-related topics and employ it to understand variations in pure ESG alpha. Using monthly firm ESG ratings from three sources as available during 1991-2019 and associated stock characteristics and returns during December 1992 through December 2020, with tests spanning December 2002 through December 2020, they find that: Keep Reading

Financial media and expert commentators often cite the U.S. unemployment rate as an indicator of economic and stock market health, generally interpreting a jump (drop) in the unemployment rate as bad (good) for stocks. Conversely, investors may interpret a falling unemployment rate as a trigger for increases in the Federal Reserve target interest rate (and adverse stock market reactions). Is this variable in fact predictive of U.S. stock market behavior in subsequent months, quarters and years? Using monthly seasonally adjusted unemployment rate from the U.S. Bureau of Labor Statistics (BLS) and monthly S&P 500 Index levels during January 1948 (limited by unemployment rate data) through June 2021, we find that: Keep Reading

U.S. job gains or losses receive prominent coverage in the monthly financial news cycle, with media and expert commentators generally interpreting employment changes as an indicator of future economic and stock market health. One line of reasoning is that jobs generate personal income, which spurs personal consumption, which boosts corporate earnings and lifts the stock market. Are employment changes in fact predictive of U.S. stock market behavior in subsequent months, quarters and years? Using monthly seasonally adjusted non-farm employment data from the U.S. Bureau of Labor Statistics (BLS) and monthly S&P 500 Index levels during January 1939 (limited by employment data) through June 2021, we find that: Keep Reading

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 June 2021, we find that: Keep Reading

Is outperformance of green (environmentally friendly) stocks relative to brown (not environmentally friendly) stocks due to firm performance or concern about the climate? In other words, do green stocks carry a climate concern premium? In their June 2021 paper entitled “Dissecting Green Returns”, Lubos Pastor, Robert Stambaugh and Lucian Taylor examine relative performance of green and brown stocks in the context of unexpectedly strong increases in environmental concerns (climate concern jumps). Specifically, they:

• Construct a green factor as the return on a portfolio that is each month long (short) green (brown) stocks weighted by greenness based on environment-focused elements of MSCI ESG Ratings.
• Devise and test a 2-factor (market and green) model of stock returns.
• Compute a monthly measure of public climate concern based on an associated media index, with focus on series jumps.

Using stock return and factor data during November 2012 (based on availability of ESG ratings) through December 2020 and climate concern data during November 2012 through June 2018, they find that: Keep Reading

How sensitive are returns of stocks, bonds and gold to levels real interest rates (nominal rates minus inflation)? To investigate, we consider three nominal interest rates and two measures of inflation, as follows:

• 3-month U.S. Treasury Bill Yield (3-month).
• 1-year U.S. Treasury Constant Maturity Rate (1-year).
• 10-year Treasury Constant Maturity Rate (10-year).
• Personal Consumption Expenditures: Chain-type Price Index (PCEPI).
• Personal Consumption Expenditures Excluding Food and Energy: Chain-Type Price Index (Core PCEPI).

These choices offer six alternative real interest rates. We use end-of-month interest rates and inflation measures lagged by one month to account for release delay. We use the S&P 500 Index (SP500) capital gain only, the 10-year yield (with bond prices moving inversely) and spot gold price, all measured end-of-month, to represent returns for stocks, bonds and gold. We then relate monthly changes in real interest rates to asset class monthly returns in two ways: (1) calculate correlations of monthly real interest rates to asset class returns for each of the next 12 months to get a sense of how real rates lead asset returns; and, (2) calculate average asset class monthly returns by ranked tenths (deciles) of prior-month real interest rates to discover any non-linear relationships. Using monthly PCEPI and Core PCEPI since January 1961, interest rates since January 1962, SP500 level since December 1961 and spot gold price since December 1974 (when controls are removed), all through May 2021, we find that:

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Does the Fama-French  5-factor model (market, size, book-to-market, profitability, investment) of stock returns work for stocks worldwide? In their May 2021 paper entitled “Size, Value, Profitability, and Investment Effects in International Stock Returns: Are They Really There?”, Nusret Cakici and Adam Zaremba test the performance of the 5-factor model in global developed markets. They consider big and small stocks separately. They consider four regions (North America, Europe, Japan and Asia-Pacific), as well as the global market. They lag all accounting data by six months and calculate returns in U.S. dollars. Using data in U.S. dollars for 65,000 stocks from 23 countries during December 1987 through March 2019 (with tests starting July 1990), they find that:

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Should investors consider adding Special Purpose Acquisition Company (SPAC) Initial Public Offerings (IPO), which boomed in 2020, to their portfolios? In the March 2021 revision of their paper entitled “SPACs”, Minmo Gahng, Jay Ritter and Donghang Zhang examine investor returns on SPACs during the two phases of their lifecycle:

1. SPAC phase– from SPAC IPO to five trading days before completion of target business merger or, if no merger within 24 months, liquidation. To measure investor returns for this phase, they assume purchases of one SPAC unit (usually a common share and warrants) at IPO prices for 114 SPACs during January 2010 through May 2018. The investor sells each component at the higher of the market price or the redemption price.
2. deSPAC phase – from the first trading day as a merged company. For this phase, there are 114 completed mergers (105 having warrants), including 97 from the above SPAC phase plus 17 additional SPACs.

Using price data for U.S. SPACs (not those traded in Over-The-Counter markets) during January 2010 through October 2020, they find that:

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