Thursday, March 28, 2024

Value and momentum ARPs complement each other

 


The paper, "A Global Macroeconomic Risk Model for Value, Momentum, and Other Asset Classes" looks at why value and momentum is an good combination of alternative risk premiums as a portfolio from the perspective of sensitivity to macro factors.  Past work has shown that value and momentum complement each other given their low correlation, but there has not been a good rationale for this combination. The authors in this paper try to look at different macro factor loading to answer this question. 

For their macro factors, they use the Chen, Roll, and Ross (CRR) macroeconomic risk factors. The CRR factors are a well-defined set which includes the term premium, default premium, industrial production, expected inflation, and unexpected inflation.

The negative correlation between value and momentum is caused by the different sensitivities to macro factors. Value has a strong positive load to the term spread but negative factor loading on all the other macro features. In the case of momentum, there is a negative close to zero loading on the term premium, but there are strong positive loading on the other four macro factors, growth in industrial production, unexpected inflation, change in expected inflation and the default spread. Nevertheless, because the factor loadings are different, it is not the case that forming an equal weighted portfolio between value and momentum will lead to a portfolio that is market neutral to macro factor loadings.  Changing the weights will give an investor a tilt to the loadings desired. 







Wednesday, March 27, 2024

New Fed Financial Conditions Index points to more liquidity

 


The Fed has developed a new measure for financial conditions. This is not the first measure, and it is not clear this is a better measure. There are several financial condition indices from brokerage firms and Bloomberg. The objective is the same for all these indices. They try and provide some indication on whether financial conditions are loose or tight. If the FC index is showing tight conditions, there may be a reason for the Fed to lower rates. Alternatively, if FC conditions are loose, there may be a reason for the Fed to tighten. See: "A New Index to Measure U.S. Financial Conditions."

The new Fed financial conditions index has a different take on what is measured. It looks at what is defined as the financial conditions impulse response to growth. It looks at the change in seven input variables which the Fed funds rate, the 10-year yield, the 30-year mortgage rate, the BBB corporate bond yield, the DJ stock index, the Zillow house price index and the nominal dollar index which are weighted using an impulse response coefficient that measure the cumulative effect of unanticipated permanent changes in each of the inputs with real GDP over some forward period. which is then called the FCI-G or financial conditions impulse on Growth. The index looks at the contribution to GDP growth for 1 or 3-years using three-month changes. 

Right now, the Fed FC index is showing loose conditions after a 2022 which showed tight conditions. Note that these financial variables will be impact by stability and their contribution to wealth creation. If the Fed follows this index as a guide, it provides a focus on financial well being. 





Sunday, March 24, 2024

Macro factor investing can exploit opportunities

 


"A Century of Macro Factor Investing - Diversified Multi-Asset Multi-Factor Strategies through the Cycles" explains how a portfolio of diversified factor strategies can be created to protect or exploit specific macro risk exposures through computing macro factor mimicking portfolios (MFMP). Using a wide a set of factors, the researchers create growth, inflation, defensive, and parity portfolios and then compare against different market environments. They find that these portfolios can effectively generate return during positive environments; however, there is the ongoing problem of predicting when these environments will occur. These MFMP portfolios will do better than portfolios just associated with macro factor exposures. 

The data show that defensive portfolios will do a good job across all environments and are well diversified.  The authors go on to show that creating portfolios that include forecasts on the macro environment and factor momentum will do better than static portfolios. Active management in a Black-Litterman framework can effectively add value to a portfolio of alternative risk premium.

Based on a century of data, ARP portfolios focused on macro exposures can add value over the long-term.




Saturday, March 23, 2024

The magnificent 7 stocks are just too big! Think again

 


The truth is that the U.S. stock market was far more concentrated in the 1950s and 1960s.  Looking at Schlingemann and Stulz (2022), for example, we see that:4

  • In the mid-1950s, just three stocks accounted for about 28% of the market cap of the whole market (Figure 8). Obviously, this implies the market then was much more concentrated than seven stocks being 29% of the S&P 500 today.

  • For many decades, the biggest stock in the market was always one of the following three: IBM, AT&T, or GM (Figure 6).

  • A single stock (AT&T) was 13% of the whole market in 1960 (Table 5), as opposed to today where our largest stock (Apple) is a mere 7% of the S&P 500.

  • In terms of employment, concentration was also far higher previously.  The authors write, “For 1953, GM is the top firm in market capitalization. It employs 1.39% of non-farm employees. In 2019, Apple’s employment contribution is 0.11% (or less than one twelfth GM’s employment contribution in 1953).”

4. Schlingemann, Frederik P., and RenĂ© M. Stulz. “Have exchange-listed firms become less important for the economy?.” Journal of Financial Economics 143.2 (2022): 927-958.

From Acadian 


Yes, I have been worried about the size of the "magnificent seven" and its impact on benchmarks and passive investing, yet the story is a little bit more complex. If you look at 1980 to the present, the sizes of these stocks are large as a percentage of the total market; however, if we go back further in time, we have a very different picture. I should have done more work to think about investment history.

The question is not about the size, but the distortion of the benchmarks that are used to handicap managers and are used for massive passive investing. If you invest in the SPX, you will have to give a large portion your money to seven stocks. We just don't know what will happen if there is an exogenous shock to the markets and there is a large exit from equities. Those seven will see a large outflows; nevertheless, does this create a special problem or will it just be a fact of life.