Fundamental value strategies

November 13, 2021

Value opportunities arise when market prices deviate from contracts’ present values of all associated entitlements or obligations. However, this theoretical concept is difficult and expensive to apply. Instead, simple valuation ratios, such as real interest rates or equity earnings yields with varying enhancements, have remained popular. Moreover, value strategies can take a long time to pay off and positive returns may be concentrated on episodes of “critical transitions”.
Historically, it has been easier to predict relative value between similar contracts rather than absolute value. Also, simple valuation ratios become more meaningful when combined with related economic indicators. Thus, long-term bond yields are plausibly related to inflation expectations and the correlation of bond prices with economic cycles and market trends. Equity earnings yields can be enhanced by economic trends and market information. And effective exchange rates become a more meaningful metric when combined with inflation differentials and measures of competitiveness of a currency area.

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Accounting data as investment factors

July 24, 2021

Corporate balance sheet data are important building blocks of quantitative-fundamental (“quantamental”) investment factors. However, accounting terms are easily misunderstood and confused with economic concepts. Accounting is as much driven by assessment of risk as it is by economic value. For example, earnings are recognized only when receipt of cash is highly certain. Investment spending is recognized as such only when there is a high probability of related payoffs. Acknowledging links to risk and the double-entry system, accounting data can be combined into factors that capture the information that they jointly convey. For example, earnings yields become a more meaningful indicator when also considering return on equity and expended investment ratios.

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A market-to-book formula for equity strategies

June 26, 2021

A new proxy formula for equity market-to-book ratios suggests that (the logarithm of) such a ratio is equal to the discounted expected value of (i) differences between return on equity and market returns and (ii) the net value added from share issuance or repurchases. A firm with a higher market-to-book ratio must have lower future returns, higher return on equity, or more valuable growth or repurchase opportunities. One can cleanly decompose return forecasts into forecasts of future profitability, investment, and the market-to-book ratio at any horizon. Empirical evidence confirms that market-to-book ratios predict returns in the long run, but only to the extent that the ratio itself is not affected by profitability and investment. Indeed, profitability and investment value-added jointly explain about 60% of variations in market-to-book ratio and – hence – should be taken into consideration for investment strategies based on valuation ratios. This broader view helps to forecast returns on value stocks versus growth stocks.

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Markets’ neglect of macro news

June 12, 2021

Empirical evidence suggests that investors pay less attention to macroeconomic news when market sentiment is positive. Market responses to economic data surprises have historically been muted in high sentiment periods. Behavioral research supports the idea that investors prefer heuristic decision-making and neglect fundamental information in bullish markets, but pay more attention in turbulent times. This allows prices to diverge temporarily from fundamentals and undermines the conventional risk-return trade-off when sentiment is high. Low-risk portfolios tend to outperform subsequently. The sentiment bias also means that fundamental predictors of market prices work better in low-sentiment periods than in high-sentiment periods.

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The relation between value and momentum strategies

July 20, 2019

Simple value and momentum strategies often end up with opposite market positions. One strategy succeeds when the other fails. There are two plausible reasons for this. First, value investors regularly bet against market trends that appear to ‘have gone too far’ by standard valuation metrics. Second, value stocks carry particularly high market risk or ‘bad beta’ and thus fare well when market risk premia are high and the market turns for the better. This typically coincides with ‘momentum crashes’ in oversold markets. As a consequence, value and momentum signals may be complementary. In particular, value strategies are not very profitable in normal times or bull markets but have produced extraordinary profits when being set up in the mature state of a bear market. Similarly, momentum signals can be adjusted by extreme valuation metrics alongside signs of trend exhaustion.

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The fundamental value trap

January 5, 2019

Fundamental value seems like a straightforward investment approach. One simply looks for assets that are “cheap” or “expensive” relative to their rationally expected risk-adjusted discounted cash flows. In reality, conscientious estimation of fundamental value gaps is one of the most challenging strategies in asset management. It requires advanced financial modeling and often long waiting times for payoff. Few managers have the resources and patience for it. In macro trading, cheapness or dearness is commonly inferred from simple valuation metrics, such as real interest rates, real exchange rates or equity earnings yields. However, by themselves, off-the-shelve metrics cannot create much information advantage. Indeed, they regularly confuse forward-looking expectations with mispricing and lure investors into crowded value traps. Fundamental value should be estimated conscientiously or not at all. The minimum requirement for a valid valuation metric is some reasonable integration with related economic states and trends.

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Equity values and credit spreads: the inflation effect

December 29, 2018

A theoretical paper shows that a downward shift in expected inflation increases equity valuations and credit default risk at the same time. The reason for this is “nominal stickiness”. A slowdown in consumer prices reduces short-term interest rates but does not immediately reduce earnings growth by the same rate, thus increasing the discounted present value of future earnings. At the same time, a downward shift in expected inflation increases future real debt service and leverage of firms and increases their probability of default. This theory is supported by the trends in U.S. markets since 1970. It would principally argue for strategic relative equity-CDS positions inversely to the broad trend in expected inflation.

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The predictability of market-wide earnings revisions

October 13, 2018

Forward earnings yields are a key metric for the valuation of an equity market. Helpfully, I/B/E/S and DataStream publish forward earnings forecasts of analysts on a market-wide index basis. Unfortunately, updates of these data are delayed by multiple lags. This can make them inaccurate and misleading in times of rapidly changing macroeconomic conditions. Indeed, there is strong empirical evidence that equity index price changes predict future forward earnings revisions significantly and for all of the world’s 25 most liquid local equity markets. This predictability can be used to enhance the precision of real-time earnings yield data and avoid misleading trading signals.

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Earnings yields, equity carry and risk premia

September 8, 2018

Forward earnings yields and equity carry are plausible indicators of risk premia embedded in equity index futures prices. Data for a panel of 25 developed and emerging markets from 2000 to 2018 show that index forward earnings yields have been correlated with market uncertainty across countries and time. Earnings yields have been highest in emerging countries. However, equity carries have not, because they depend on local funding conditions and only indicate the country risk premium that is specific to equity. Both yield and carry metrics display convincing and consistent positive correlation with subsequent index futures returns. Simulations show that for proper equity long-short strategies active volatility adjustment of both signals and positions is essential in order to balance risk premia with the actual state of riskiness of the market.

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Seasonal effects in commodity futures curves

July 7, 2018

Seasonal fluctuations are evident for many commodity prices. However, their exact size can be quite uncertain. Hence, seasons affect commodity futures curves in two ways. First, they bias the expected futures price of a specific expiry month relative that of other months. Second, their uncertainty is an independent source of risk that affects the overall risk premia priced into the curve. Integrating seasonal factor uncertainty into an affine (linear) term structure model of commodity futures allows more realistic and granular estimates of various risk premia or ‘cost-of-carry factors’. This can serve as basis for investors to decide whether to receive or pay the risk premia implied in the future curve.

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Macrosynergy is a London based macroeconomic research and technology company whose founders have developed and employed macro quantamental investment strategies in liquid, tradable asset classes, across many markets and for a variety of different factors to generate competitive, uncorrelated investment returns for institutional investors for two decades. Our quantitative-fundamental (quantamental) computing system tracks a broad range of real-time macroeconomic trends in developed and emerging countries, transforming them into macro systematic quantamental investment strategies. In June 2020 Macrosynergy and J.P. Morgan started a collaboration to scale the quantamental system and to popularize tradable economics across financial markets.

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