Chart of the Week - Jefferies Makes the Case for Small Caps in 2023
via Jefferies
…as pair-wise correlations in small caps continued to rise and are at their highest level since May '20
Valuations and Earnings Growth Rates
by Larry Swedroe
Since investors care most about cumulative growth rather than persistence of growth, Chingono and Obenshain also looked at cumulative growth over the next one to five years to determine if past winners continued to outgrow the market median on a cumulative basis.
As you can see, the outcomes for the highest-trailing growth quintile are indistinguishable from the outcomes in the lowest-trailing growth quintile. Past winners essentially have the same long-term outcomes as past losers in terms of cumulative EBITDA (earnings before interest, taxes, depreciation and amortisation) growth.
The historical evidence demonstrates that an investment strategy that bets on growth is a strategy likely to disappoint because growth is neither persistent nor predictable and because value stocks should have an embedded risk premium (noting that risks, of course, can and do show up).
It’s likely that the evidence presented won’t settle the debate about whether the value premium is risk- or behavioral-based (if the latter is the case, the value premium is a free lunch). However, the answer to the question doesn’t have to be black or white. Perhaps the value premium, while not being a free lunch (there’s plenty of evidence supporting a risk-based explanation), is at least a free stop at the dessert tray for those investors willing to accept their incremental economic cycle risk.
Option Gamma and Stock Returns
by Amar Soebhag
Stocks with high net gamma exposure robustly underperform stocks with low net gamma exposure by 10% per year. This effect is distinct from multiple previously documented return predictors, and survives many robustness checks. We show that stocks with low net gamma exposure negatively predicts future realized volatility. We argue that investors command a risk premium to hold low net gamma exposure stocks, which are riskier. Lastly, we show that the volatility predictability stems from a non-informational channel, and not from private information.
The Factor Multiverse: The Role of Interest Rates in Factor Discovery
by van Binsbergen, Jules H. and Ma, Liang and Schwert, Michael
The past five decades have witnessed the discovery of a very large number of asset pricing anomalies, sometimes referred to as the “factor zoo.” Over this same sample period, there has been a long-term decline in interest rates. We study the importance of this decline in the discovery of asset pricing anomalies. We investigate 153 discovered anomalies as well as 1,395 potential undiscovered anomalies and find that absent the interest-rate decline, the asset pricing literature would likely entertain a different set of anomalies today. As such, our analysis highlights the sensitivity of the factor discovery process to this specific observed non-stationary economic time period. Our paper raises broader questions regarding the importance of secularly declining economic variables for the robustness of anomaly returns. The secular decline in economic growth rates and population growth numbers are important candidates to consider. Given that some of these variables have been declining for centuries, the recent out-of-sample evidence on anomaly patterns that only go back further by a number of decades, may not be sufficient.
How Competitive is the Stock Market? Theory, Evidence from Portfolios, and Implications for the Rise of Passive Investing
by Haddad, Valentin and Huebner, Paul and Loualiche, Erik
We develop a framework to theoretically and empirically analyze how investors compete with each other in financial markets. In the classic view that markets are fiercely competitive, if a group of investors changes its behavior, other investors adjust their strategies such that nothing happens to prices. We propose a demand system with a flexible degree of strategic response and estimate it for institutional investors in the U.S. stock market. Investors react to the behavior of others in the market: when less aggressive traders surround an investor, she trades more aggressively. However, this strategic reaction is not nearly as strong as the classic view. Our estimates suggest that when a group of investors changes its behavior, the response of other investors only counteracts half of the direct impact. This result implies that the rise in passive investing over the last 20 years has led to substantially more inelastic aggregate demand curves for individual stocks by about 15%.
Predicting Growth Isn’t the Same as Predicting Returns
by Larry Swedroe
The historical evidence makes clear that abnormal earnings growth (both high and low) tends not to persist beyond what we would randomly expect. Thus, as Obenshain and Chingono demonstrated, betting on a company to persistently produce abnormal earnings growth has been a loser’s game—a painful lesson for investors in ARKK, Cathie Wood’s Innovation ETF, which bet on abnormal earnings growth. As of October 15, 2022, the fund had Morningstar one-, three- and five-year percentile rankings of 100 (worst performer), 99 and 95, respectively. The takeaway is that investors need to be very humble when forecasting earnings growth, understanding that abnormal earnings revert to the mean (GDP growth rate) very quickly, and that by five years there is no abnormal growth beyond the randomly expected.
Are Hedge Funds Losing Their Hedge?
by David H Bailey
Bloomberg reports that approximately $25 billion was withdrawn from long-short U.S. equity hedge funds from January 2022 through August. Net withdrawals over the past five years have topped $100 billion.
What went wrong? Bloomberg’s Nishant Kumar observes,
The decline of long-short equity hedge funds has been years in the making. Part of the problem may be that they got out of the habit of hedging. Many managers’ tactics were honed during a decade of low interest rates that powered rising share prices. They could make money with leveraged bets on high-flying stocks. Even so, as a group, equity hedge funds underperformed a simple S&P 500 index fund in strong bull market years like 2013 and 2019. Now portfolios loaded with growth and technology shares and just a smattering of shorts have captured most of the downside in this market.
Some predict a retrenchment of sorts, particularly in the long-short sector. Edoardo Rulli, deputy chief investment officer at UBS, for one, predicts that a reset in may be coming, leaving only the stronger players standing. “Formation of new funds will go down; the number of funds will possibly shrink. … It’s not a bad thing.”
Predicting Recessions Using VIX-Yield Curve Cycles
by Anne Lundgaard Hansen
The VIX index and the spread between long- and short-term Treasury bond yields co-move in counterclockwise cycles that align with the business cycle. Based on this empirical fact, I predict U.S. recessions using an indicator of the economy's location on the VIX-yield curve cycle. The proposed indicator significantly outperforms the yield curve spread in predicting U.S. recessions from 1950-2022 both in- and out-of-sample and using both static and dynamic probit models. VIX-yield curve cycles also contain predictive power above and beyond other leading economic indicators.
Fair Multiples - How should we estimate the terminal multiple?
by Dan Rasmussen and Greg Obenshain
So an analyst focused on determining the terminal multiple on a stock should start with the premise that multiples will dramatically mean revert but give companies with higher gross margins and free cash flow a higher terminal multiple than the market average. But how much higher?
Below we show the base rates of three-year forward multiples by quintiles of starting multiples, gross profit margins and free cash flow conversion.
Figure 6: 3Y FWD TEV/EBITDA Multiples by Quintile of Starting ValueSource: S&P Capital IQ, Verdad Research.
While starting multiples have a very wide range, they converge toward the median, but not completely. The fair range of multiples, as indicated by GP/sales and FCF/EBITDA is fairly tight, between 8x and 12x EBITDA. This is not full mean reversion, but it is close.
High multiple companies tend to keep a premium valuation even if that valuation tends to fall as growth is realized. But fundamentals like margins and free cash flow do in fact drive long-term valuations, and that range of valuations is very tight. Over the long run, there are mostly 8–12x EBITDA companies trading at valuations temporarily outside of that range, rather than 5–30x EBITDA companies that will stay that way forever.
The Pre-FOMC Announcement Drift
by David O. Lucca and Emanuel Moench
We document large average excess returns on U.S. equities in anticipation of monetary policy decisions made at scheduled meetings of the Federal Open Market Committee (FOMC) in the past few decades. These pre-FOMC returns have increased over time and account for sizable fractions of total annual realized stock returns. While other major international equity indices experienced similar pre-FOMC returns, we find no such effect in U.S. Treasury securities and money market futures. Other major U.S. macroeconomic new announcements also do not give rise to pre-announcement excess equity returns. Pre-FOMC returns are higher in periods when the slope of the Treasury yield curve is low, implied equity market volatility is high, and when past pre-FOMC returns have been high. We discuss challenges explaining these returns with standard asset pricing theory.
Anxiety in Returns
by Pigorsch, Uta and Schäfer, Sebastian
We provide empirical evidence that risk-averse investors avoid stocks with signs of increasing uncertainty, missing 1.02 percentage points in next-month returns. The observed effect counteracts short-term reversal and supports convex risk aversion. Moreover, anxiety predicts cross-sectional returns in out-of-sample tests, strongly suggesting that empirical risk premia are driven by predictable risk-averse investors' preferences.