Insights

• Enhanced Index Investing, May 2013 (Clients Only)

  Posted May 20 2013 by in Applied Quantitative Strategy

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  • We use three weighting techniques to identify if these alternative weighting techniques outperform the standard value weighting technique.
  • We conduct three different monthly-adjusted weighting techniques on the universe of the 500 largest firms:
    • The first is to equal weight each stock.
    • The second is to weight based on momentum (higher momentum gets a higher weight).
    • The last is to weight based on volatility (higher volatility gets a lower weight).
  • We also test annual rebalancing to minimize trading costs.
  • All three alternative weighting schemes outperform the value-weight technique.
  • The volatility and the momentum weighting techniques outperform the equal-weighting technique.
  • At the margin, volatility weighting has the best performance.

• Behavioral Finance Spotlight: May 2013

  Posted May 15 2013 by in Behavioral Finance Spotlight

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  Abstract:

  A question of increasing interest to researchers in a variety of fields is whether the biases found in judgment and decision-making research remain present in contexts in which experienced participants face strong economic incentives. To investigate this question, we analyze the decision making of National Football League teams during their annual player draft. This is a domain in which monetary stakes are exceedingly high and the opportunities for learning are rich. It is also a domain in which multiple psychological factors suggest teams may overvalue the chance to pick early in the draft. Using archival data on draft-day trades, player performance and compensation, we compare the market value of draft picks with the surplus value to teams provided by the drafted players. We find that top draft picks are significantly overvalued in a manner that is inconsistent with rational expectations and efficient markets and consistent with psychological research.

  Empiritrage Comments:

  • Behavioral biases can lead to market inefficiencies.
  • Paper undervalues the new collective bargaining agreement signed by the NFL in 2011 , which actually makes top picks more valuable.
    • Andrew Luck and Robert Griffin III (2012, #1 and #2 picks, new CBA) are paid around $5 million a year, when both made the pro bowl last year.  A market contract for such a player would be at least $10-12 million per year.  In contrast Sam Bradford (2010, #1 pick, old CBA) was paid more guaranteed money than anyone in NFL history, without playing an NFL game.
  • Number 1 overall picks (Elway, P. Manning, E. Manning, and Aikman) won 8 championships.  It would be difficult to explain to your fan base that you traded away the first pick because lower picks have a higher surplus value.

• Action Required–New Email System for Empiritrage

  Posted May 5 2013 by in Uncategorized

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  If you do not take action, you will no longer receive our posts via email!

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• Tactical Asset Allocation During Cheap Markets, May 2013

  Posted May 3 2013 by in Applied Quantitative Strategy

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  • Prior research suggests that purchasing equities following trough Shiller P/E ratios, or cyclically-adjusted PE (CAPE), tends to be a good bet. Long-term returns monotonically decrease with P/E, suggesting a robust relationship between “cheapness” and subsequent returns. We confirm this previously identified relationship.

  What do we do differently?

  • We ask a question regarding opportunity costs—we know stocks perform well, but how about bonds? If bonds perform just as well following cheap equity markets, if not better on a risk-adjusted basis, the takeaway is no longer “Buy equities following trough P/E,” but perhaps “buy bonds?”…Or, “Buy both?”
    • We find that stocks have much higher CAGRs, but worse risk-adjusted statistics, suggesting that bonds should not be disregarded during trough P/E periods.
  • We also look at the benefits of diversification during extreme trough P/E regimes—should we abandon diversification and shift heavily into equities following cheap markets?
    • Diversified stock/bond portfolios outperform concentrated equity or bond portfolios following cheap markets. Diversification adds value.
  • Our final tests look at real spreads between earnings yields (1/CAPE) and real 10-year bond yields, a metric we label “Real Yield Spreads.”
    • We find that in extreme Real Yield Spread regimes, stocks earn much higher subsequent CAGRs and risk-adjusted returns.
    • Diversified portfolios of stocks/bonds underperform concentrated equity portfolios, suggesting an opportunity for tactical asset allocation in high spread environments.

• Empiritrage Q2 10-Year S&P 500 Return Forecast

  Posted Apr 17 2013 by in Quarterly Return Forecast

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  We generate projected long-term forecasts for the S&P 500 using a variety of models ranging from simple (Bob Shiller Method) to relatively complex (Empiritrage Method).

  • Shiller Method—regression approach.
    • The current predicted 10-year Nominal Total Return: 6.56%
  • Hussman Method—total return approach with assumptions on exit valuations.
    • The current predicted 10-year nominal total return ranges between: -3.05% and 6.93%
  • Empiritrage Method—simulation approach with dynamic revenue, profit margins, and valuations.
    • The current predicted 10-year nominal total return ranges between: 3.43% and 6.86%