Fundamental Valuation

Which economic and market variables are most effective in predicting U.S. stock market returns? In his October 2018 paper entitled “Forecasting US Stock Returns”, David McMillan tests 10-year rolling and recursive (inception-to-date) one-quarter-ahead forecasts of S&P 500 Index capital gains and total returns using 18 economic and market variables, as follows: dividend-price ratio; price-earnings ratio; cyclically adjusted price-earnings ratio; payout ratio; Fed model; size premium; value premium; momentum premium; quarterly change in GDP, consumption, investment and CPI; 10-year Treasury note yield minus 3-month Treasury bill yield (term structure); Tobin’s q-ratio; purchasing managers index (PMI); equity allocation; federal government consumption and investment; and, a short moving average. He tests individual variables, four multivariate combinations and and six equal-weighted combinations of individual variable forecasts. He employs both conventional linear statistics and non-linear economic measures of accuracy based on sign and magnitude of forecast errors. He uses the historical mean return as a forecast benchmark. Using quarterly S&P 500 Index returns and data for the above-listed variables during January 1960 through February 2017, he finds that: Keep Reading

Can investors time premiums associated with widely used stock/firm fundamental ratios? In their September 2018 paper entitled “It Takes Two to Tango: Fundamental Timing in Stock Market”, Fuwei Jiang, Xinlin Qi, Guohao Tang and Nan Huang use a simple moving average (SMA) trend indicator to time premiums associated with four fundamental stock/firm ratios: book-to-market (BM), earnings-to-price (EP), gross profitability (GP), and return-on-assets (ROA). In calculating these ratios, they lag accounting variables by six months to avoid look-ahead bias. For each ratio, they:

• At the end of each June, rank stocks into tenths (deciles).
• Each day, calculate value-weighted average returns for the deciles with the highest (highest BM, EP, GP, ROA) and lowest (lowest BM, EP, GP, ROA) expected returns and maintain price indexes for these two deciles.
• Each day, hold a long (short) position in the decile with highest (lowest) expected returns only when the decile price index is above (below) its 20-day SMA, indicating an upward (downward) trend. When not holding a decile, hold Treasury bills.

As benchmarks, they each year buy and hold four portfolios that are each long (short) the value-weighted deciles with the highest (lowest) expected returns for one of the fundamental ratios. While focusing on a 20-day SMA, for robustness they also test SMAs of 10, 50, 100 and 200 trading days. While focusing on value weighting, they also look at equal weighting. They run tests on both non-financial Chinese A-share stocks and non-financial U.S. common stocks. Using annual groomed fundamentals data and daily returns for Chinese stocks during January 2001-December 2017 and for U.S. stocks during July 1970-December 2017, and contemporaneous Treasury bill yields, they find that:

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A subscriber proposed four alternative ways of timing the U.S. stock market based on simple moving averages (SMA) of the market price-earnings ratio (P/E), as follows:

1. 5-Year Binary – hold stocks (cash) when P/E is below (above) its 5-year SMA.
2. 10-Year Binary – hold stocks (cash) when P/E is below (above) its 10-year SMA.
3. 15-Year Binary – hold stocks (cash) when P/E is below (above) its 15-year SMA.
4. 5-Year Scaled – hold 100% stocks (cash) when P/E is five or more units below (above) its 5-year SMA. Between these levels, scale allocations linearly.

To obtain a sample long enough for testing these rules, we use the monthly U.S. data of Robert Shiller. While offering a very long history, this source has the disadvantage of blurring monthly data as averages of daily values. How well do these alternative timing strategies work for this dataset? Using monthly data for the S&P Composite Index, annual dividends, annual P/E and 10-year government bond yield since January 1871 and monthly 3-month U.S. Treasury bill (T-bill) yield as return on cash since January 1934, all through August 2018, we find that: Keep Reading

The Mojena Market Timing strategy (Mojena), developed and maintained by professor Richard Mojena, is a method for timing the broad U.S. stock market based on a combination of many monetary, fundamental, technical and sentiment indicators to predict changes in intermediate-term and long-term market trends. He adjusts the model annually to incorporate new data. Professor Mojena offers a hypothetical backtest of the timing model since 1970 and a live investing test since 1990 based on the S&P 500 Index (with dividends). To test the robustness of the strategy’s performance, we consider a sample period commencing with inception of SPDR S&P 500 (SPY) as a liquid, low-cost proxy for the S&P 500 Index. As benchmarks, we consider both buying and holding SPY (Buy-and-Hold) and trading SPY with crash protection based on the 10-month simple moving average of the S&P 500 Index (SMA10). Using the trade dates from the Mojena Market Timing live test, daily dividend-adjusted closes for SPY and daily yields for 13-week Treasury bills (T-bills) from the end of January 1993 through August 2018 (over 25 years), we find that: Keep Reading

Are there any gold trading strategies that reliably beat buy-and-hold? In their April 2018 paper entitled “Investing in the Gold Market: Market Timing or Buy-and-Hold?”, Viktoria-Sophie Bartsch, Dirk Baur, Hubert Dichtl and Wolfgang Drobetz test 4,095 seasonal, 18 technical, and 15 fundamental timing strategies for spot gold and gold futures. These strategies switch at the end of each month as signaled between spot gold or gold futures and U.S. Treasury bills (T-bill) as the risk-free asset. They assume trading frictions of 0.2% of value traded. To control for data snooping bias, they apply the superior predictive ability multiple testing framework with step-wise extensions. Using monthly spot gold and gold futures prices and T-bill yield during December 1979 through December 2015, with out-of-sample tests commencing January 1990, they find that:

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Which factor models of stock returns are currently best? In their June 2018 paper entitled “q⁵“,  Kewei Hou, Haitao Mo, Chen Xue and Lu Zhang, introduce the q⁵ model of stock returns, which adds a fifth factor (expected growth) to the previously developed q-factor model (market, size, asset growth, return on equity). They measure expected growth as 1-year, 2-year and 3-year ahead changes in investment-to-assets (this year total assets minus last year total assets, divided by last year total assets) as forecasted monthly via predictive regressions. They define an expected growth factor as average value-weighted returns for top 30% 1-year expected growth minus bottom 30% 1-year expected growth, calculated separately and further averaged for big and small stocks. They examine expected growth as a standalone factor and then conduct an empirical horse race of recently proposed 4-factor, 5-factor (including q⁵) and 6-factor models of stock returns based on their abilities to explain average return differences for value-weighted extreme tenth (decile) portfolios for 158 significant anomalies. Using monthly return and accounting data for a broad sample of non-financial U.S. common stocks during July 1963–December 2016, they find that:

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Do changes in firm financial reporting practices signal bad news to come? In the February 2018 update of their paper entitled “Lazy Prices”, Lauren Cohen, Christopher Malloy and Quoc Nguyen investigate relationships between changes in firm financial reporting practices (SEC 10-K, 10-K405, 10-KSB and 10-Q filings) and future firm/stock performance. They focus on quarter-to-quarter changes in content bases on four distinct textual similarity metrics. Each month, they rank all firms into fifths (quintiles) for each of the four metrics. They then compute equally weighted or value-weighted returns for these quintiles over future months (such that there are overlapping portfolios for each quintile and each metric), with stock weights within quintile portfolios rebalanced monthly for equal weighting. They measure the effect of changes in financial reporting practices as monthly return for a hedge portfolio that is long (short) the quintile with the smallest (greatest) past changes. Using the specified quarterly and annual SEC filings by U.S. corporations from the Electronic Data Gathering, Analysis, and Retrieval (EDGAR) database and corresponding monthly stock returns during 1995 through 2014, they find that:

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How well do different measures of stock quality perform as portfolio screens? In the May 2018 update of paper entitled “Does Earnings Growth Drive the Quality Premium?”, Georgi Kyosev, Matthias Hanauer, Joop Huij and Simon Lansdorp review commonly used quality definitions, test their respective powers to predict stock returns and analyze usefulness in constructing international stocks and corporate bonds settings. They consider the following definitions of quality:

• Industry – return on equity (ROE); earnings-to-sales ratio (margin); annual growth in ROE; total debt-to-common equity (leverage); and, earnings variability.
• Academia – gross profitability; accruals; and, net stock issues.

To compare predictive powers, at the end of each month they rank assets into fifths (quintiles) based on each metric and examine equally weighted performances of these quintiles. They calculate gross annualized average excess returns (relative to the risk-free rate) and gross annualized Sharpe ratios for the top and bottom quintiles and the difference between these two quintiles (top-minus-bottom). They also calculate four-factor (market, size, book-to-market and momentum) alphas for top-minus-bottom portfolios. They further analyze equally weighted combinations of all industry metrics and all academic metrics. They consider the largest stocks globally, regionally and from emerging markets. For robustness, they also consider samples of investment-grade and high-yield corporate bonds (with a 12-month rather than one-month holding interval). Using samples of relatively large non-financial common stocks for developed markets (starting December 1985) and emerging markets (starting December 1992) and samples of investment-grade and high-yield corporate bonds (starting January 1994) through December 2014, they find that: Keep Reading

Do firms with predictable sales seasonality continually “surprise” investors with good high season (bad low season) sales and thereby have predictable stock return patterns? In their May 2018 paper entitled “When Low Beats High: Riding the Sales Seasonality Premium”, Gustavo Grullon, Yamil Kaba and Alexander Nuñez investigate firm sales seasonality as a stock return predictor. Specifically, for each quarter, after excluding negative and zero sales observations, they divide quarterly sales by annual sales for that year. To mitigate impact of outliers, they then average same-quarter ratios over the past two years. They then each month:

1. Use the most recent average same-quarter, two-year sales ratio to predict the ratio for next quarter for each firm.
2. Rank firms into tenths (deciles) based on predicted sales ratios.
3. Form a hedge portfolio that is long (short) the market capitalization-weighted stocks of firms in the decile with the lowest (highest) predicted sales ratios.

Their hypothesis is that investors undervalue (overvalue) stocks experiencing seasonally low (high) sales. They measure portfolio monthly raw average returns and four alphas based on 1-factor (market), 3-factor (market, size, book-to-market), 4-factor (adding momentum to the 3-factor model) and 5-factor (adding profitability and investment to the 3-factor model) models of stock returns. Using data for a broad sample of non-financial U.S common stocks during January 1970 through December 2016, they find that: Keep Reading

Is use of a sampling interval much shorter than input variable measurement interval a useful statistical practice in financial markets research? In the April 2018 update of their paper entitled “Long Horizon Predictability: A Cautionary Tale”, flagged by a subscriber, Jacob Boudoukh, Ronen Israel and Matthew Richardson examine statistical reliability gains from overlapping measurements of long-horizon variables (such as daily or monthly sampling of 5-year returns or 10-year moving average earnings). They employ the widely used cyclically adjusted price earnings ratio (CAPE, or P/E10) for some examples. Based on illustrations and mathematical derivations, they conclude that: Keep Reading