Earnings are a key return driver for the stock market.
Investors can actively manage portfolio risk based on variables such as equity risk premium and the evolution of earnings estimates.
Presenting a quantitative system that rotates between stocks and bonds based on those two factors.
The system produces solid returns over the long term, and it does a great job in terms of controlling for downside risk during bear markets.
The main idea is not that investors should blindly replicate a system such as this one, but incorporating these factors into risk management decisions makes a lot of sense.
The stock market is essentially a market of stocks, and stocks are ultimately a share in the ownership of a business. For this reason, the earnings generated by those businesses are crucial return drivers for stock prices over time.
The following paragraphs are presenting a quantitative strategy that rotates between stocks and bonds using SPDR S&P 500 (SPY) and iShares 7-10 Year Treasury Bond ETF (IEF). The strategy is based on earnings numbers as a key valuation metric and as a measure of overall fundamental trends for decision-making. Backtested results are quite solid, especially in terms of reducing portfolio drawdown during bear markets.
The main idea is not that investors should replicate this overly simplistic quantitative strategy in real life, but rather showing how watching the equity risk premium and the main trends in earnings revisions can be remarkably effective when managing portfolio risk.
The equity risk premium has multiple interpretations and different methods for calculation. A simple formula for such a metric is taking the difference between the earnings yield for companies in the S&P 500 versus the 10-year Treasury bond yield. This interpretation would say that when the earnings yield of the stock market is higher than long-term treasury yield the market is undervalued, and vice versa.
Like all other valuation metrics, the equity risk premium has both its advantages and limitations. However, it makes sense to compare the earnings yield on stocks versus the returns available in the bond market, since stocks and bonds are the two main building blocks of portfolio construction.
In order for the quantitative system to be invested in SPY, the equity risk premium needs to be above 1%, meaning that stocks are relatively well priced in comparison to bonds.
In addition to analyzing if stocks are cheap or expensive, we also need to consider that the main trends in earnings expectations can have a big impact on subsequent returns. If earnings are declining due to a recession or some kind of economic problem on the horizon, this generally pushes stock prices lower, regardless of the initial valuation levels.
For this reason, the strategy requires the 5-day moving average in earnings estimates for companies in the S&P 500 to be above the 21-day moving average in order to buy stocks.
Wrapping up, when the equity risk premium is above 1% and earnings estimates are increasing, the quantitative strategy is invested in stocks via SPDR S&P 500. Conversely, when the equity risk premium is below 1% or earnings expectations are declining, the strategy moves to bonds via iShares 7-10 Year Treasury Bond ETF.
The following backtest begins in January of 1999, the strategy is rebalanced every four weeks, and trading expenses are assumed to be 0.2% per transaction. The numbers look quite good in terms of both risk and return, with the strategy gaining 754.85% versus 223.47% for a buy and hold position in SPDR S&P 500 in the same period. The strategy alpha amounts to 7.89% annually.
Even more important, the maximum drawdown - meaning the maximum decline in portfolio value from the peak - is 20.15% for the quantitative strategy versus a much larger drawdown of 55.42% for buy and hold investors in stocks. This represents a massive difference in risk, and it's arguably the most important advantage in the quantitative strategy.
Data from S&P Global via Portfolio123
Looking at returns over different periods, we can see that the strategy underperforms versus buy and hold in the past five years. This is because stocks have substantially outperformed bonds in this period. While the strategy was only allocated to bonds for brief periods of time, this had a negative impact on returns.
You have to expect false signals from time to time, meaning periods in which the strategy goes for safety, but the pullback in stocks is ultimately shallow and short-lived. No strategy can provide the right signals on every occasion, and these kinds of strategies are ultimately about reducing portfolio risk, not so much about increasing returns.
Some observations regarding the historical allocations for the strategy:
- From January of 1999 until January of 2003, the strategy was allocated to bonds; first, because stocks were overvalued in 1999, and then, because earnings expectations were declining during the recession in 2001 and 2002.
- Due to declining earnings during the great recession in 2008 and 2009, the strategy was also allocated to bonds from June of 2018 until July of 2009.
- These two protective moves during big markets produced massive benefits in terms of historical performance for the quantitative strategy.
- The strategy also produced several false signals in other periods, but most of those false signals were short-lived; none of them lasted for more than two months.
- This means that the pain from being allocated to underperforming bonds when stocks were delivering superior returns would have been quite tolerable.
In simple terms, most of the outperformance produced by the quantitative strategy was due to avoiding deep bear markets during the tech bubble and in the financial crisis. In times of smoother returns for stocks, a strategy such as this one will most probably underperform versus buy and hold. That said, the periods of underperformance would be relatively brief.
The quantitative strategy is based on remarkably simplistic assumptions, being either 100% in stocks or 100% in bonds depending on absolute values for the equity risk premium and earnings trends. This is only to illustrate how these concepts work and what kind of performance they tend to produce in the long term.
A more reasonable approach for investors to implement in real life would be keeping a well-diversified allocation and reducing exposure to stocks when the equity risk premium is low, meaning that stocks are relatively overvalued, and when earnings revisions are pointing downwards, meaning that the fundamental outlook is deteriorating.
The chart below shows how the equity risk premium is currently above 3.8%, substantially above the 1% threshold employed by the quantitative strategy.
Data from S&P Global via Portfolio123
There has been some uncertainty regarding the potential impact of the trade war and global economic jitters on the US economy recently, but the fact remains that earnings estimates for companies in the S&P 500 remain near historical highs.
Data from S&P Global via Portfolio123
Looking at both the equity risk premium and the main trend in earnings revision, the data looks supportive for stock prices as of the time of this writing.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.