In this post I’ll bring in a simple trading strategy that is well varied and has been proven to work across different marketplaces. In short, buying cheap and trending shares has historically resulted in notably higher returns. The strategy is a combination of the two different investment styles, value, and momentum.
In a previous post I described how the range of possible final results in trading into an individual market is exorbitant. Therefore, global diversification is the main element to make sure that you reach your investment objective. This strategy is diversified across strategies, markets, and different stocks. The benefits of this strategy are the low implementation costs, a higher diversification level, higher expected earnings, and lower drawdowns.
We’ll use data from Barclays for the CAPEs which represent valuations, and Yahoo Finance using quantmod for the returns that do not include dividends, which we’ll use as complete momentum. Let’s take a look at the paths of valuation and momentum for the U.S. Both corrections are easy to spot, because the momentum was low, and valuations decreased. The U.S. stock market currently has a solid momentum as measured by the six-month overall return, but the valuation level is really high. Which means U.S. is not the optimal country to purchase. So, which market is the optimal place to be?
There is one market that is just in the right spot: Russia. It has the highest momentum and second least expensive valuation of all nationwide countries in this sample. In emerging markets things happen faster and more intensively, which leads to more opportunities and makes buying them more interesting. Different markets also tend to be in different cycles, which makes this mixture strategy more attractive even. Let’s discuss more about these strategies and why they work well together. Value and momentum factors are correlated, meaning when the other you have low earnings, the other one’s earnings have a tendency to be higher.
Both have been found to lead to excessive returns and are two of the most researched so-called anomalies. Both strategies have been tried to be explained using behavioral and risk-based factors, but no single explanation has been agreed on for either of the strategies. The fact that we now have multiple explanations for the superior performance can rather be viewed as a very important thing for the strategies.
In their publication “Your Complete Guide to Factor-Based Investing”, Berkin and Swedroe discovered that the annual returns of both anomalies utilizing a long-short strategy was 4.8 percent for value and 9.6 percent for the momentum anomaly. This corresponds to the come back of the factor itself and can straight be set alongside the market beta factor, which has had a historical annual comeback of 8.3 percent during the same period.
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This means that trading just in the momentum factor and for that reason hedging against the market would have resulted in a higher return than just investing in the market. It is important to notice that investing normally just utilizing a momentum strategy without shorting gives exposure to both of the marketplace beta and momentum factors, which leads to a higher return than investing into either of the factors just.
Andreu et al. Analyzed momentum on the united states level and found out that the return of the momentum factor has been about 6 percent per annum for a holding period of six months. For a holding period of a year, the return was cut in half (source). It seems that a brief keeping period appears to work for this momentum strategy best. They researched investing in a single country and three countries at a time and shorting the same number of countries at the same time.
The smaller number of countries resulted in higher returns, but no risk measures were offered in the analysis. As a short-term strategy I’d suggest equal weighting a few of the countries with high momentum and low valuation. I’ve also tested the mixture of value and momentum in the U.S. Value on the other hand tends to correlate strongly with future earnings only on a lot longer periods, and on shorter periods the correlation is close to zero as I showed in a previous post. However, the short-term CAGR of the value strategy on the national country level in the U.S.
14.5 percent for a CAPE proportion of 5 to 10, as shown by Faber (source, amount 3A). I thought we would show this specific valuation level, since presently countries such as Turkey and Russia are trading at these valuation levels (source). The 10-year cyclically altered price to profits ratio that was talked about in the last chapter, also known as CAPE, has been proven to be one of the better variables for explaining the future earnings of the stock market.