Sentiment Indicators

A subscriber requested verification of findings in “Smart Money Indicator for Stocks vs. Bonds”, where the Smart Money Indicator (SMI) is a complicated variable that exploits differences in futures and options positions in the S&P 500 Index, U.S. Treasury bonds and 10-year U.S. Treasury notes between institutional investors (smart money) and retail investors (dumb money). To verify, we simplify somewhat the approach for calculating and testing SMI, as follows:

• Use a “modern” sample of weekly Traders in Financial Futures; Futures-and-Options Combined Reports from CFTC, starting in mid-June 2006 and extending into early February 2020.
• For each asset, take Asset Manager/Institutional positions as the smart money and Non-reporting positions as the dumb money.
• For each asset, calculate weekly net positions of smart money and dumb money as longs minus shorts. 
• For each asset, use a 52-week lookback interval to calculate weekly z-scores of smart and dumb money net positions (how unusual current net positions are). This interval should dampen any seasonality.
• For each asset, calculate weekly relative sentiment as the difference between smart money and dumb money z-scores.
• For each asset, use a 13-week lookback interval to calculate recent maximum/minimum relative sentiments between smart money and dumb money for all three inputs. The original study reports that short intervals work better than long ones, and 13 weeks is a quarterly earnings interval.
• Use a 13-week lookback interval to calculate final SMI as described in “Smart Money Indicator for Stocks vs. Bonds”.

We perform three kinds of tests to verify original study findings, using dividend-adjusted SPDR S&P 500 (SPY) as a proxy for a stock market total return index, 3-month Treasury bill (T-bill) yield as return on cash (Cash) and dividend-adjusted iShares 20+ Year Treasury Bond (TLT) as a proxy for government bonds. We calculate asset returns based on Friday closes (or Monday closes when Friday is a holiday) because source report releases are normally the Friday after the Tuesday report date, just before the stock market close. 

1. Calculate full sample correlations between weekly final SMI and both SPY and TLT total returns for lags of 0 to 13 weeks.
2. Calculate over the full sample average weekly SPY and TLT total returns by ranked tenth (decile) of SMI for each of the next three weeks after SMI ranking.
3. Test a market timing strategy that is in SPY (cash or TLT) when SMI is positive (zero or negative), with 0.1% (0.2%) switching frictions when the alternative asset is cash (TLT). We try execution at the same Friday close as report release date and for lags of one week (as in the original study) and two weeks. We focus on compound annual growth rate (CAGR) and maximum drawdown (MaxDD) as key performance metrics. Buying and holding SPY is the benchmark.

Using inputs as specified above for 6/16/06 through 2/7/20, we find that: Keep Reading

Do differences in expectations between institutional and individual investors in stocks and bonds, as quantified in weekly legacy Commitments of Traders (COT) reports, offer exploitable timing signals? In the February 2019 revision of his paper entitled “Want Smart Beta? Follow the Smart Money: Market and Factor Timing Using Relative Sentiment”, flagged by a subscriber, Raymond Micaletti tests a U.S. stock market-U.S. bond market timing strategy based on an indicator derived from aggregate equity and Treasuries positions of institutional investors (COT Commercials) relative to individual investors (COT Non-reportables). This Smart Money Indicator (SMI) has three relative sentiment components, each quantified weekly based on differences in z-scores between standalone institutional and individual net COT positions, with z-scores calculated over a specified lookback interval:

1. Maximum weekly relative sentiment for the S&P 500 Index over a second specified lookback interval.
2. Negative weekly minimum relative sentiment in the 30-Year U.S. Treasury bond over this second lookback interval.
3. Difference between weekly maximum relative sentiments in the 10-Year U.S. Treasury note and 30-year U.S. Treasury bond over this second lookback interval.

Final SMI is the sum of these components minus median SMI over the second specified lookback interval. He considers z-score calculation lookback intervals of 39, 52, 65, 78, 91 and 104 weeks and maximum/minimum relative sentiment lookback intervals of one to 13 weeks (78 lookback interval combinations). For baseline results, he splices futures-only COT data through March 14, 1995 with futures-and-options COT starting March 21, 1995. To account for changing COT reporting delays, he imposes a baseline one-week lag for using COT data in predictions. He focuses on the ability of SMI to predict the market factor, but also looks at its ability to enhance: (1) intrinsic (time series or absolute) market factor momentum; and, (2) returns for size, value, momentum, profitability, investment, long-term reversion, short-term reversal, low volatility and quality equity factors. Finally, he compares to several benchmarks the performance of an implementable strategy that invests in the broad U.S. stock market (U.S. Aggregate Bond Total Return Index) when a group of SMI substrategies “vote” positively (negatively). Using weekly legacy COT reports and daily returns for the specified factors/indexes during October 1992 through December 2017, he finds that: Keep Reading

Are there relationships between (1) the stock market outlook expressed by a U.S. equity mutual fund manager in semi-annual reports and (2) positioning and performance of that fund? In his October 2019 preliminary paper entitled “Are Professional Investors Prone to Behavioral Biases? Evidence from Mutual Fund Managers”, Mehran Azimi examines these relationships. Specifically, for each such U.S. equity mutual fund semi-annual report, he:

1. Uses a word list to identify parts of fund reports that may contain stock market outlooks.
2. Applies machine learning to isolate sentences most likely to present outlooks.
3. Manually reads and rates these sentences as bearish, neutral or bullish.
4. Computes fund manager “Belief” as number of bullish sentences minus number of bearish sentences divided by the total number of sentences isolated. Positive (negative) Belief indicates a net bullish (bearish) outlook.

He then employs regressions to relate fund manager Belief to fund last-year return, asset allocation, portfolio risk and next-year 4-factor (adjusting for market, size, book-to-market and momentum) alpha. Using 40,731 semi-annual reports for U.S. equity mutual funds and associated fund characteristics, holdings and returns during February 2006 through December 2018, he finds that:

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Can investors apply deep learning software to expose obscure but useful management sentiment in firm SEC Form 10-K filings? In their July 2019 paper entitled “Is Positive Sentiment in Corporate Annual Reports Informative? Evidence from Deep Learning”, Mehran Azimi and Anup Agrawal apply deep learning to detect positive and negative sentiments at the sentence level in 10-Ks. They train their model using 8,000 manually evaluated sentences randomly selected from 10-Ks. They then use the trained model to assign sentiments to all sentences in each 10-K. Their overall measure of negative (positive) sentiment is number of negative (positive) sentences divided by the total number of sentences in the 10-K. They assess impact of 10-K sentiment on stock performance based on 4-factor (market, size, book-to-market, momentum) alpha during short intervals after 10-K filing. Using 10-K filings for non-utility and non-financial U.S. public firms with at least 200 words, associated daily stock prices/trading volumes and daily 4-factor alphas during January 1994 through December 2017, they find that: Keep Reading

Do sentiment indexes usefully predict U.S. stock market returns? In his May 2018 doctoral thesis entitled “Forecasting Market Direction with Sentiment Indices”, flagged by a subscriber, David Mascio tests whether the following five sentiment indexes predict next-month S&P 500 Index performance:

1. Investor Sentiment – the Baker-Wurgler Index, which combines six sentiment proxies.
2. Improved Investor Sentiment – a modification of the Baker-Wurgler Index that suppresses noise among input sentiment proxies.
3. Current Business Conditions – the ADS Index of the Philadelphia Federal Reserve Bank, which combines six economic variables measured quarterly, monthly and weekly to develop an outlook for the overall economy.
4. Credit Spread – an index based on the difference in price between between U.S. corporate bonds and U.S. Treasury instruments with matched cash flows. (See “Credit Spread as an Asset Return Predictor” for a simplified approach.)
5. Financial Uncertainty – an index that combines forecasting errors for large sets of economic and financial variables to assess overall economic/financial uncertainty.

He also tests two combinations of these indexes, a multivariate regression including all sentiment indexes and a LASSO approach. He each month for each index/combination predicts next-month S&P 500 Index return based on a rolling historical regression of 120 months. He tests predictive power by holding (shorting) the S&P 500 Index when the prediction is for the market to go up (down). In his assessment, he considers: frequency of correctly predicting up and down movements; effectiveness in predicting market crashes; and, significance of predictions. Using monthly data for the five sentiment indexes and S&P 500 Index returns during January 1973 through April 2014, he finds that: Keep Reading

How does news flow interact with short-term stock market return? In their April 2019 paper entitled “Forecasting the Equity Premium: Mind the News!”, Philipp Adämmer and Rainer Schüssler test the ability of a machine learning algorithm, the correlated topic model (CTM), to predict the monthly U.S. equity premium based on information in news articles. Their news inputs consist of about 700,000 articles from the New York Times and the Washington Post during June 1980 through December 2018, with early data used for learning and model calibration and data since January 1999 used for out-of-sample testing. They measure the U.S. stock market equity premium as S&P 500 Index return minus the risk-free rate. Specifically, they each month:

1. Update news time series arbitrarily segmented into 100 topics (with robustness checks for 75, 125 and 150 topics).
2. Execute a linear regression to predict the equity premium for each of the 100 topical news flows.
3. Calculate an average prediction across the 100 regressions.
4. Update a model (CTM^Sw) that switches between the best individual topic prediction and the average of 100 predictions, combining the flexibility of model selection with the robustness of model averaging.

They use the inception-to-date (expanding window) average historical equity premium as a benchmark. They include mean-variance optimal portfolio tests that each month allocate to the stock market and the risk-free rate based on either the news model or the historical average equity premium prediction, with the equity return variance computed from either 21-day rolling windows of daily returns or an expanding window of monthly returns. They constrain the equity allocation for this portfolio between 50% short and 150% long, with 0.5% trading frictions. Using the specified news inputs and monthly excess return for the S&P 500 Index during June 1980 through December 2018, they find that:

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Do “bubble” stocks (those with high shorting demand and small borrowing supply) exhibit unconventional momentum behaviors? In their December 2018 paper entitled “Overconfidence, Information Diffusion, and Mispricing Persistence”, Kent Daniel, Alexander Klos and Simon Rottke examine how momentum effects for bubble stocks differ from conventional momentum effects. They each month sort stocks into groups independently as follows:

1. Momentum winners (losers) are the 30% of stocks with the highest (lowest) returns from one year ago to one month ago, incorporating a skip-month.
2. Stocks with high (low) shorting demand are those with the top (bottom) 30% of short interest ratios.
3. Stocks with small (large) borrowing supply are those with the top (bottom) 30% of institutional ownerships.

They then use intersections of these groups to reform 27 value-weighted portfolios. Bubble (constrained) stocks are those in the intersection of high shorting demand and low institutional ownership, including both momentum winners and losers. For purity, they further split bubble losers into those that were or were not also bubble winners within the past five years. Using monthly and daily returns, market capitalizations and trading volumes for a broad sample of U.S. common stocks, monthly short interest ratios and quarterly institutional ownership data from SEC Form 13F filings during July 1988 through June 2018, they find that: Keep Reading

Does combining the wisdom of multiple stock-picking models via ensemble methods, as done in forecasting landfall of hurricanes, improve investment portfolio performance? In their September 2018 paper entitled “Ensemble Active Management”, Alexey Panchekha, Robert Tull and Matthew Bell test the application of ensemble methods to active portfolio management, looking for consensus or near-consensus among multiple, independent stock picking sources. Ensemble diversification tends to neutralize biases among individual sources when: (1) sources are independent; (2) sources employ different approaches; and, (3) most sources achieve at least 50% individual accuracies. As sources, they use the holdings and weights of 37 actively managed U.S. equity large-capitalization mutual funds, focusing on high-conviction stock selections (those with large mismatches with respect to market capitalization). Specifically, every two weeks they:

• Reform 30,000 randomly generated clusters of 10 mutual funds.
• For each cluster, reform a long-only Ensemble Active Management (EAM) portfolio consisting of the 50 stocks with the highest consensus overweights within the cluster.
• Calculate total returns for EAM portfolios, their respective clusters and the S&P 500 Index.

They debit performance of each EAM portfolio by the average contemporaneous expense ratio of the 37 mutual funds (average 0.94% across all years). To aggregate results, they calculate rolling 1-year and 3-year performances of EAM portfolios, mutual fund clusters and the index. Using daily estimated stock holdings and weights for the 37 mutual funds and associated stock prices as available during July 2007 through December 2017, they find that:

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Quantitative investing involves disciplined rule-based approaches to help investors structure optimal portfolios that balance return and risk. How has such investing evolved? In their June 2018 paper entitled “The Current State of Quantitative Equity Investing”, Ying Becker and Marc Reinganum summarize key developments in the history of quantitative equity investing. Based on the body of research, they conclude 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