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John Hussman's Peak PE Ratio as a Long Term Stock Market Indicator
John Hussman, manager of Hussman Strategy Growth Fund (HSGFX) proposed price to peak 10 year average earnings as a long term stock market valuation metric. Compared with the normal one year price to earning ratio, Price to Peak Earnings would eliminate short term noise. This is similar to Shiller's ‘Cyclically Adjusted Price Earning’ ratio (CAPE10) and Warren Buffett’s stock market GNP/GDP metric. In his weekly commentary on Dec 5, 2005, titled as 'Earnings Revert to the Mean, Stocks Will Struggle', he proposed a simplistic method: "buy when Price to Peak Earnings is lower than 15 and sell when it exceeds 19.5". John Hussman has been using this as the valuation yardstick to manage the Hussman Strategic Growth Fund HSGFX.
It is interesting to examine how effective using such a metric as a long term stock market timing indicator. Similar to the Warren Buffett’s stock market GNP/GDP metric and Shiller's CAPE, the following strategy characterizes the stock market valuation into the following five categories based on the ratio of the current Peak PEs to the long term average Peak PEs:
More »Follow the Smart Money Asset Allocation
Various techniques have been used for this purpose. One of widely followed methods is to track mutual funds monthly money flows. This approach could only give us monthly information, which is not exactly very timely in a fast changing market. A more serious problem with this is that it only could tell us how the investors move money among various assets such as equities, fixed incomes and commodities. It does not really reveal what allocations mutual fund managers are making. Furthermore, this would not give us any information how 'smart' managers are doing.
Some other similar approaches are mostly focused on sentiments. For example, Hulbert Financial Digest has been tracking investment newsletters' bullish/bearish sentiments on equity and gold. Investment newsletters represent a small fraction of the investment opinions. Other well known sentiment indicators include Investors Intelligence's bullish/bearish poll as well as AAII (American Association of Individual Investors) bullish/bearish poll. These indicators offer insights into certain types of investors. They are mostly used as contrarian indicators.
ValidFi recently introduced Pro Money (Asset Allocation) Indicator and Smart Money (Asset Allocation) Indicator. Both indicators track moderate allocation funds' asset exposures US equities and US aggregate bonds. The technique behind these indicators is to derive timely quantitative asset exposures by directly analyzing a fund's beta exposures for various assets such as US equities and fixed income. The Pro Money Indicator is based on the aggregate asset exposure from majority of US moderate allocation mutual funds (481 funds total). The Smart Money indicator is based on the average exposure among a selected list of top funds. These top funds are selected based on their past risk adjusted returns as well as their consistent performance during market downturns. The indicators are updated weekly. Using Pro Money and Smart Money Indicators, we create weekly adjusting portfolios separately. The asset allocations of US equities and US bonds (using Vanguard Total Stock Market Index Fund VTSMX and Vanguard Total Bond Index Fund VBMFX as proxies) are derived based on the indicators' allocations. The following table compares these two portfolios and Vanguard Balanced Index Fund VBINX.
From the table, one could see that Pro Money is closely matched to VBINX. This is not surprising as Pro Money is tracking the majority of US balanced funds asset allocation. Arguably, the above table only shows a short history. The model portfolios of strategy Guru Asset Allocation Clone have longer history. This strategy uses the same technique to arrive at asset allocation decisions. The risk and return of model portfolios like this show the effectiveness of this technique.
So what are the current Pro and Smart Money allocations? From the following two charts, one could see that the Pro US equity allocation has steadily risen since April until late September. The Smart Money US equity allocation is somewhat interesting: with a steep rise since July (recall Dow Theory, along with other indicators, gave buy signals during that time), it had a large reduction in early September but immediately increased to around 75%. Also pay special attention to the last week's (10/26-10/30) allocation changes: instead of reducing the equity allocation along with the general market correction (during the week, VTSMX dropped 5.6%), the Pro actually slightly increased the equity allocation while Smart Money decreased its equity exposure 9% (from 78.4% to 69.2%)! Call it stubborn bullishness!
ValidFi Smart Money Equity Allocation
Disclosure: No Positions
Robert Shiller's Cyclically Adjusted Price Earning Ratio as a Long Term Timing Indicator
It is interesting to examine how effective using such a metric as a long term stock market timing indicator. Similar to the Warren Buffett's stock market metric, ValidFi implements and maintains a live strategy called Shiller Cyclically Adjusted PE 10 Stock Market Timing Strategy. One of its model portfolios buys stocks only when this ratio is deemed to be significantly under valued (the current CAPE10 is 33% lower than the long term CAPE10 average) and goes into cash when such as ratio signals significant over valued (if the current CAPE10 is 50% higher than its long term average). The stock market exposure is through buying Wilshire 5000 total return index (^DWC). From 12/31/1970 to 10/23/2009, the weekly adjusted portfolio achieves 7.5% annualized return and standard deviation 9.5% compared with Wilshire 5000 total return's annualized return 6.9% and standard deviation 19.5%. Such a portfolio was in cash from 7/17/1987 all the way to 3/6/2009! See the following chart:
It is hard to believe that an average investor would have such patience to stay out of the stock market for such a long time, especially during the bull markets. However, a prudent investor would utilize such an indicator to carefully manage the risk during over valued periods.
Some readers might ask that since Shiller's indicator is a long term indicator, what strategies one could use during the long time periods when it is out of stock market. We will have follow up articles on how to combine such a long term indicator and some safe strategies to achieve safe and more reasonable returns.
Disclosure: No Positions
Halloween Indicators Issue Buy Signals: Now What?
Mark Hulbert recently published a story on marketwatch.com: Hybrid Halloween Indicators. The original Halloween indicator (or sometimes called "sell in May and go away") has been studied extensively. In his story, Hulbert mentioned a research paper published in 2002 in his article. The paper found that most stock markets around the globe indeed exhibited such abnormality: "sell in early May and buy in late October" could achieve excessive risk adjusted return. The improved strategy proposed by Sy Harding (detailed description could be found here and here) issued a buy signal on Friday Oct. 16, 2009. This strategy uses MACD to further pinpoint the buy/sell dates around April and October time frames. It is pertinent to compare such a strategy with the original strategy as well as with the buy and hold strategy at this time. The "original" strategy dictates that one sell on April 26th and buy on October 16th. The following table compared the performance of the three strategies from 7/1/1971 to 10/16/2009. All of them use Wilshire 5000 total return index as the proxy to the stock market investment and use 13 week treasury bill as the cash when they are out of the stock market.
From the table, one could see that the "improved" strategy does the best in terms of overall return and risk. Overall, one could clearly see that both "original" and "improved" strategies have outperformed the buy and hold strategy.
From the above graph, we could see that the "improved" strategy waited till the end of 2008 to get into the stock market, thus sidestepping some loss that the "original" strategy incurred during the October to December time frame. Unfortunately, both of them suffered a great deal from the March steep decline. This is a clear reminder that such strategies are not fool proof and they are still subject to stock market's big swing. Given the steep run-up of the stock market so far, a favorable seasonality backdrop should be treated just as a backdrop: one should not blindly follow the strategy alone but instead, taking such a statistical evidence into consideration during your portfolio management such as portfolio rebalancing.
Disclosue: No Positions
Even In Slow Boring Fixed Income Investing, Hot Hands Are Still Hot
Momentum effect, i.e. a phenomenon that past 'hot' funds or assets will continue to be 'hot' in a certain future period, has been widely recognized as a market inefficiency, both by practitioners and academic researchers. Momentum based strategies have been proposed in equity (stocks), commodities and asset allocation investing (see this article for more information).
Less well known is that momentum effect exists even in boring and slowly moving fixed income (bonds) markets. In a recent research paper titled 'Hot Hands' in Bond Funds by Derwall, Jeroen and Huij, Joop, it is shown that investing based on past performance momentum in bond funds could earn statistically significant returns. In practice, FundX's Janet Brown has a long running investment newsletter on a technique called 'Upgrading'. One of its model portfolios is based on selecting bond funds based on a momentum score. Utilizing such a method, FundX now manages a mutual fund FundX Flexible Income (INCMX).
We construct a model portfolio that selects a bond fund monthly or quarterly among a list of funds whose managers have won Morningstar's fixed income manager of the year award since 7//30/2000. In the back testing during the past 9 years, both monthly and quarterly based portfolios have achieved more than 10% annualized return. The following table compares the two portfolios performance (from 7/30/2000 to 10/10/2009):
Compared with one of the best bond funds, Pimco's Total Return Fund PTTRX (managed by Bill Gross who won Morningstar's manager of the year award in 1998, 2000 and 2007), both monthly and quarterly adjusted portfolios outperform it. The following chart shows the comparison between PTTRX and the quarterly adjusted portfolio.
At the moment, both portfolios pick Loomis Sayles Bond Instl (LSBDX) as their investment.
In addition to actively managed bond mutual fund momentum, the index bond ETFs or mutual funds also exhibit good momentum. This is subject to other discussions in the future.
Disclosures: No Positions
Even In Slow Boring Fixed Income Investing, Hot Hands Are Still Hot
Momentum effect, i.e. a phenomenon that past 'hot' funds or assets will continue to be 'hot' in a certain future period, has been widely recognized as a market inefficiency, both by practitioners and academic researchers. Momentum based strategies have been proposed in equity (stocks), commodities and asset allocation investing (see our previous article for more information).
Less well known is that momentum effect exists even in boring and slowly moving fixed income (bonds) markets. In a recent research paper titled 'Hot Hands' in Bond Funds by Derwall, Jeroen and Huij, Joop, it is shown that investing based on past performance momentum in bond funds could earn statistically significant returns. In practice, FundX's Janet Brown has a long running investment newsletter on a technique called 'Upgrading'. One of its model portfolios is based on selecting bond funds based on a momentum score. Utilizing such a method, FundX now manages a mutual fund FundX Flexible Income (INCMX).
ValidFi maintains various types of bond fund momentum based strategies. One model portfolio selects a bond fund monthly or quarterly among a list of funds whose managers have won Morningstar's fixed income manager of the year award since 7//30/2000. In the past 9 years, both monthly and quarterly based portfolios have achieved more than 10% annualized return. The following table compares the two portfolios performance (from 7/30/2000 to 10/10/2009):
Compared with one of the best bond funds, Pimco's Total Return Fund PTTRX (managed by Bill Gross who won Morningstar's manager of the year award in 1998, 2000 and 2007), both monthly and quarterly adjusted portfolios outperform it. The following chart shows the comparison between PTTRX and the quarterly adjusted portfolio.
At the moment, both portfolios pick Loomis Sayles Bond Instl (LSBDX) as their investment.
In addition to actively managed bond mutual fund momentum, the index bond ETFs or mutual funds also exhibit good momentum. We will have more follow up articles to detail these investing strategies.
Disclosures: No Positions