Strategy Preference Can Indicate Expected Stock Market Return

Rather surprisingly, the equity strategy framework can provide an estimate of current expected stock market returns. This is accomplished by measuring the recent investor response to each strategy, which, it turns out, captures the deep behavioral currents driving market returns. The resulting information is useful when managing equity market exposure.

Investment strategies were first introduced in this series as an alternative to the Style Grid for forming active equity mutual fund peer groups. Follow-up articles discussed the advantage of diversifying equity portfolios based on fund strategy, how to identify the best funds within each strategy, when stock picking works best, and how fund managers overweight their best-idea stocks. We close the series examining the power of strategies for estimating expected market returns.

Market Factors and the Strategy Market Barometer

As we know, aggregate stock market returns are driven by the collective buy and sell decisions of individual and institutional investors. Many market factors enter into their decisions, and the relative importance of each factor evolves over time. At times, investors place more importance on economy-wide data, stock market activity or specific industry sectors or stocks.

When estimating overall market expected returns, it is important to know the current mix of factors favored by investors. Our research at AthenaInvest has identified 10 equity strategies, introduced in this article, that active equity managers pursue in order to generate superior returns. Each strategy focuses on a specific set of market factors. For example, Competitive Position (CP) fund managers might focus on innovative companies, building an investment process around factors such as strong management and defensible market positions.

A strategy's most recent return rank relative to other strategies varies over time because investors collectively focus on a changing mix of factors. However, investment managers usually pursue their investment strategies regardless of whether they are in favor with investors. Managers keep doing the same thing while investors change their focus, which provides a stable prism for viewing what is being favored by investors at a given time.

The Strategy Market Barometer (SMB) developed out of our research captures the factors being rewarded at any given time. A high SMB means that market participants favor a high-return factor mix, while a low SMB means participants favor a low-return mix. Consequently, a high SMB implies a high expected market return, and a low SMB a low expected return.

Instead of revealing whether recent market returns have been positive or negative, SMB focuses on relative strategy return ranks. The SMB can be high or low regardless of recent market performance.

SMB is not a traditional measure of market sentiment but instead captures actual investor behavior. Strategy return ranks are the result of collective investment activity, so they reflect what investors do rather than how they feel about market conditions. The SMB is a "put your money where your mouth is" type of measure.

Calculating and Using SMB

Monthly strategy index returns are calculated by averaging the monthly returns for all funds in a given strategy. The 2,000 or so U.S. active equity mutual fund monthly returns used are net of any automatically deducted fees.

For example, the SMB reading in Figure 1 is calculated using trailing 12-month strategy return rank absolute deviations from the 1988-2007 historical ranks shown in the right-hand table. The top performing U.S. equity strategy over this 20-year period was Future Growth, while the bottom performer was Risk. Risk underperformed Future Growth by 600 basis points annually over this period.

Figure 1: Strategy Ranks and Expected Market Returns

Figure 1 provides a graphical representation of the relationship between strategy ranks and expected market returns. If current strategy ranks align with long-term ranks, then expected returns are high. This means investors are currently favoring strategies in the same order they have performed over the long run. More specifically, investors are favoring Future Growth stocks and Competitive Position stocks. This is a positive sign for the market and leads to expected returns well above the 10% long-term average.

Conversely, if ranks are inverted in relationship to long-term ranks, investors instead are rewarding Risk, Social Considerations, Economic Conditions and Market Conditions stocks, which are historically weaker strategies. This is a bad sign for the market because it indicates investors are taking a defensive position rather than focusing on long-term stock market drivers. As a result, the expected market return is weak or even negative. For example, Social Considerations, Risk and Market Conditions were top relative strategies in 2008, a bad sign for the market. And we know what happened in 2008.

Strategy ranks most often fall in between aligned and inverted and, as a result, the expected market return of the U.S. stock market is somewhere around the long-term average of 10%. A separate SMB is used for developed global markets and U.S. markets and each has proven effective in capturing macro-level crowd behavior.

Figure 2: Return Distribution Shift Based on SMB

As demonstrated in Figure 2, the SMBs can be used to vary equity exposure in different markets from none to long to leveraged, something AthenaInvest has successfully done since 2010 with its global tactical ETFs portfolio.

Increasingly, advisors are developing flexibility in their asset allocation strategy to respond to market changes. Tactical strategies help with this goal. SMBs are part of a growing body of research using behavioral metrics and active equity management to help investors and advisors improve portfolio returns through market exposure.

— Read the rest of this series here:

Thomas Howard, Ph.D., is the CEO and chief investment officer at AthenaInvest and a professor emeritus at the Reiman School of Finance, Daniels College of Business, University of Denver. He can be reached at [email protected]