Improvements in Market Valuations Are on Their Way

Most long-term trading strategies stumbled in 2008 Q4. As investors panicked and hedge funds delivered, it seems that stock prices over the last three months were heavily influenced by short-term earnings, dividend yield, and price momentum as some investors looked for safe havens in the stock market, and others simply followed macro trends. Despite poor performance during the market decline, we believe that a long-term valuation approach will perform very well as an investment strategy as the stock market stabilizes, and the following article will summarize what we have observed during the stock market decline (9/19/2008 - 11/21/2008) and the recent recovery over the last six weeks.

(Source: Value Expectations.com)

Over the course of the last 15 weeks (beginning on 9/19/2008, which is roughly the date of the Lehman Brothers bankruptcy), we have taken weekly snapshots of the stock market. Each week, we have tracked the performance of many commonly used metrics to get a better sense of what variables are impacting investor decisions. The following table highlights the performance of the overall stock universe (defined as US publicly-traded companies with analyst estimates, including ADRs) between 9/19/2008 and 11/21/2008, as well as the Russell 2000, Russell 1000, S&P 500, and the Value and Growth universes as defined by Market Value / Net Invested Capital:

(Source: Value Expectations.com)

We can see from here that, on an equal-weighted basis, the overall universe declined 45.2% over this period of time. An interesting observation lies within the research of Valuation and Momentum based metrics. To keep this simple, we will narrow our focus to Percent to Target as our valuation metric and Price Return - 3 Month as our momentum metric. (The performance of these variables is measured as the percentage spread between the equal-weighted return of the top half of the universe vs. the equal-weighted return of the bottom half of the universe.)

As the market declines, a momentum based strategy built on Price Return - 3 Month performs well, but as the market improves, a valuation based strategy based on Percent to Target - Current performs well. Over this nine week period, we observed significant declines in market values in seven of these nine weeks, and a momentum based trading strategy would have performed very well over this period (relative to its benchmark - all trading strategies were negative over this time). Note that for the entire universe, the top half of Price Return outperformed the bottom half of Price Return by 31.4% over this time frame, while the top half of Percent to Target underperformed the bottom half of Percent to Target by 12.4%.

Moving forward from 11/21/2008, we observe a very interesting reversal in the performance of these trading strategies:

(Source: Value Expectations.com)

Over the six weeks between 11/21/2008 and 1/2/2009, we see a radical improvement in market valuations - nearly 27.3% for the overall universe, and over 31% for the Russell 1000 & 2000. Note that weekly trends still continue to hold true - as market valuations improve a Valuation-based strategy performs well, and as the market valuations decline, a Momentum-based strategy performs well.

Conclusion:

As we have observed stock market improvement over the last six weeks, we have also seen a remarkable improvement in the performance of a value-based strategy, and we expect this trend to continue into 2009 as we move into a more stable trading environment.

Comments

[bagnap:]

Have you considered Saturn, and the movement of Venus through the orbit of Mars?

Jan 13 04:14 PM