Market timing with Value and Momentum

Market timing with Value and Momentum

July 22, 2015 Uncategorized
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Yesterday we wrote a post showing a potential way to time the market using valuation-based signals. In the past we have also examined how to use momentum-based signals (moving average rules and time-series momentum) to time the market.

A natural question is what happens when we combine the valuation-based signals with the momentum-based signals?

Here at Alpha Architect, we are big believers in Value and Momentum. We have written about how to combine Value and Momentum in the security selection process here and here.

In this post, we examine what happens when we combine valuation-based (value) signals with momentum-based (MA rule) signals.

Here is the setup, from yesterday’s post:

Strategy Background:

We use 1/CAPE as the valuation metric, or the “earnings yield,” as a baseline indicator; however, we adjust the yield value for the realized year-over-year (yoy) inflation rate, by subtracting the year-over-year inflation rate from the rate of 1/CAPE.

To summarize, the metric looks as follows if the CAPE ratio is 20 and realized inflation (Inf) is 3%:

Real Yield Spread Metric = (1/20)-3% = 2%

Some details:

  • Bureau of Labor Statistics (BLS) publishes the CPI on a monthly basis since 1913; however, the data is one-month lagged (possibly longer). For example, the CPI for January won’t be released until February. So when we subtract the year-over-year inflation rate from the rate of 1/CAPE, we do 1-month lag to avoid look-ahead bias.
  • We use the S&P 500 Total Return index as a buy-and-hold benchmark.

So the two signals we will use are the following:

Valuation-based signal:

  • 80th Percentile Valuation based asset allocation: own S&P500 when valuation < 80th percentile, otherwise hold risk-free
    • In other word, if last month’s CAPE valuation is in the 80 percentile or higher (data starting 1/1924), buy U.S. Treasury bills (Rf); otherwise stay in the market.

Momentum-based signal:

  • Long-term moving average rule on the S&P 500 (own the S&P 500 if above 12-month MA, risk-free if below the 12-month MA).

Results are gross of any fees.  All returns are total returns and include the reinvestment of distributions (e.g., dividends). Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Our back test period is from 1/1/1934 to 12/31/2014.

Baseline Results:

Here we show the results to 4 portfolios:

  1. Valuation-based market timing: Own S&P500 when valuation < 80th percentile, otherwise hold risk-free.
  2. Momentum-based market timing: Own the S&P 500 if above 12-month MA, risk-free if below the 12-month MA.
  3. Risk-free: Total return to owning U.S. Treasury Bills.
  4. SP500: Total return to the S&P500.
CAPE_1
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

As previously noted, both Valuation and Momentum-based timing models increase Sharpe and Sortino ratios, while decreasing drawdowns.

Now let’s combine them.

Combining Value and Momentum Timing models:

Here we show the results to 4 portfolios:

  1. (50/50) Abs 80%, MA : Each month, allocate 50% of capital to the valuation-based timing model, and 50% or capital to the momentum-based allocation model.
  2. (and) Abs 80%, MA: Each month, examine the valuation and momentum-based signals. If both say “yes” to being in the market, invest in the S&P 500; if either or both say “no” to being in the market, invest in risk-free.
  3. (or) Abs 80%, MA: Each month, examine the valuation and momentum-based signals. If either say “yes” to being in the market, invest in the S&P 500; if both say “no” to being in the market, invest in risk-free.
  4. SP500: Total return to the S&P500.
CAPE_2
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Takeaways:

  • Combining the Value and Momentum-based signals makes sense, when using the “50/50 model” and the “(or) model.” Both of these have higher Sharpe and Sortino ratios compared to standalone value and momentum-based models.
  • The “(and) model” does not work very well — you are out of the market too often.

Conclusion:

Of course, transaction costs and taxes (not shown in the results above) need to be considered. However, it appears that combing value and momentum in market timing is promising, and something we will examine more carefully in the future.

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Please remember that past performance is not an indicator of future results. Please read our full disclaimer. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees. This material has been provided to you solely for information and educational purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and Alpha Architect to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Alpha Architect.

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About the Author

Jack Vogel, Ph.D.

Jack Vogel, Ph.D., conducts research in empirical asset pricing and behavioral finance, and is a co-author of DIY FINANCIAL ADVISOR: A Simple Solution to Build and Protect Your Wealth. His dissertation investigates how behavioral biases affect the value anomaly. His academic background includes experience as an instructor and research assistant at Drexel University in both the Finance and Mathematics departments, as well as a Finance instructor at Villanova University. Dr. Vogel is currently a Managing Member of Alpha Architect, LLC, an SEC-Registered Investment Advisor, where he heads the research department and serves as the Chief Financial Officer. He has a PhD in Finance and a MS in Mathematics from Drexel University, and graduated summa cum laude with a BS in Mathematics and Education from The University of Scranton.


  • quixoticinvestor

    Great article! Love your research. You mention controlling for the look ahead bias with the CPI number. Do you control for the look ahead bias with the valuation signal regarding the CAPE ratio? If so, how? For example, earnings for January – March are not known until May and June. When calculating the CAPE ratio (or real yield as you suggest) do you just use “stale” earnings that would have been known at the time? For example, using the above quarter, do you calculate the CAPE yield based on the 4th Quarter earnings in Jan-Mar since those numbers were known at the time? Thanks!

  • Jack Vogel, PhD

    Thanks!. Yes you would need to lag the earnings data 3 months to avoid look-ahead bias.

  • definitely makes sense…given the factors you optimize on are two of the most powerful alpha factors [known to mankind], for those with liquidity and time…
    btw, can this be applied to ETF’s…can you publish a backtest on say GDX and EZU…thanks…

  • Jack Vogel, PhD

    You could test it on those ETFs (if you had the earnings data historically for those ETFs). We stuck to the U.S. broad market to see what happens when combining value and momentum-based rules.

  • Given that ETF’s are now hitting the $3T mark and have surpassed Hedged AUM, maybe there is a market to produce rolled-up fundamental metrics for some of the more liquid ETFs…Thx.

  • Great article! How is it possible that the “(and) Abs 80%, MA” portfolio has a larger max. drawdown than the “(or) Abs 80%, MA” portfolio? Isn’t the former just a subset of the latter?

  • Jack Vogel, PhD

    Thanks! The “(and) rule” kept you out of the market from 1939-1943, and there were a few negative months in 1943.

  • Nick Wilson

    Thanks for a fascinating study. Have you tried it with a higher threshold eg 90% valuation? Seems to me that while there is a clear risk reduction, returns aren’t significantly improved especially if you were to include transaction costs. For a long term investor, being out of the market seems to only work at extremes of overvaluation and perhaps 80% is not extreme enough.

  • Jack Vogel, PhD
  • janvrots

    Would like to compare the 200MA rule to %from52weekhigh. Dont have a reference for now, but, I was under the impression distance from 52week high worked better than 200MA. Thanks

  • Jack Vogel, PhD

    Please send a link if you have the study showing that %from52weekhigh works better, thanks.

  • disqus_WDjmvSqmLH

    Thanks,
    Very interesting.
    Can you share the percent of time the strategy (each of them) spend in stocks and in bonds? It is obvious that 80% valuation strategy is 80% of the time in stocks but what about the other strategies?
    I can vaguely infer it from the cagr and std but It would be nice if you can add it to the statistics.

  • Jack Vogel, PhD

    The “or” signal is in the market ~ 89% of the time. The “and” signal is in the market ~ 48% of the time.