Thursday, 1 December 2011
One Last Free Lunch
There are a range of so-called
anomalies that have preoccupied investors for many years, largely
because they seem to offer a free lunch, which is a rare thing in
investment markets. So the momentum effect and various value-related
effects have spawned a whole host of exciting but not entirely
convincing ventures.
A range of recent research now
threatens to actually shed some light onto these anomalies suggesting
that the momentum effect has vanished and that value effects are real
but caused by idiosyncratic factors. It also suggests that mean
reversion, upon which many investing careers is based, generally works
but sometimes only if you have an investing lifetime to wait. On a
positive note, NOW might be a really good time to try and exploit it.
Losing Momentum
The momentum effect was first documented by
Jegadeesh and Titman,
who established that a strategy of holding a portfolio of winning
stocks and shorting losing stocks yielded a positive and abnormal return
over timescales of up to a year. This finding generated a whole host
of related research dedicated to explaining the effect, most of which
was mutually contradictory and which makes you go cross-eyed from
reading it.
One of the odd things we’ve
noted in the past about this type of anomaly is that actually pointing
them out often has the affect of causing them to disappear. The
explanation for this, at least, is relatively clear cut: once the effect
becomes generally known then investors will move to exploit it, and
improve the efficiency of the markets in that respect. We’ve seen a
similar occurrence in the
Death of the Accrual Anomaly.
Valuing Ignorance
So if momentum’s stopped working
what about its polar opposite, the various value effects? The size
effect – where small companies outperform large ones – and the book-to
market effect – where companies trading at or below net asset value
outperform the market – are well documented. There are, again, a wide
range of explanations for this but a lot of them focus on the idea that
these stocks outperform because they’re more risky.
In some more recent research
Kevin and Marc Aretz
manage to narrow down the range of potential causes by focussing on the
small subset of firms that actually drive these anomalies, rather than
by market wide analysis. What they show is that the main factors behind
the size and book-to-value effects appear to be idiosyncratic risk and
distress risk. Or, to put this in English, risks that are specific to
individual stocks, and not market wide.
What this implies is that a
value strategy that looks to generally exploit small firms or those
trading at a low book-to-market value that doesn’t involve detailed
analysis of the individual companies involved is flawed. Any form of
strategic ignorance is based upon ignorance of the strategy: the market
is not generally mispricing such firms based on normal risk factors, but
is specifically mispricing some firms, which require some hard research
to uncover. Which is a positive thing for those investors who spend
time digging the dirt on small value stocks.
Mythical Mean Reversion
Of course, the underlying theme behind most value strategies is the concept of mean reversion, as in
Value in Mean Reversion?,
the idea that over the long-term most company valuations will revert to
some norm after they’ve undergone a shock of some kind. Mean reversion
is almost revered in some circles and, like the concept of
just-enough-diversification we looked at in
Diworsification is Good For You,
appears to have attained mythical status amongst investors, and is
accepted, unquestioned by all. Which suggests it's exactly the kind of
target we should want to throw a few bricks at, just to see what
happens.
It’s well worth a read, but the
main finding is that mean reversion does occur. So you can all breathe a
deep sigh of relief. Although you should do this very, very slowly,
because in the worst case it can take up to 23.8 years for a stock to
return to half its previous value, which the researchers call a
‘half-life’. Which is more or less most people’s entire active
investing lifetime. Over some time periods there is no mean reversion
discernable at all.
At the other extreme a mean
reversion half-life can be as short as 2.1 years, and this level of
relatively rapid mean reversion seems to be linked to periods of extreme
economic uncertainty:
“The
highest speed of mean reversion is found for the period including
the Great Depression and the start of World War II. Similarly, the early
years of the Cold War and the period covering the Oil Crisis of 1973,
the Energy Crisis of 1979 and Black Monday in 1987 also show relatively
fast mean reversion.”
This
finding suggests that relying on mean reversion to work its magic is
probably not a generally safe bet. The implication is that when stocks
are marked down in normal economic conditions this is the market doing
its normal reasonably efficient job of accurately valuing the impact of
events; and that the recovery times are unreliable, presumably because
they’re dependent on the managers of the firms involved actually
managing the problems properly and ensuring recovery.
Waiting For Uncertainty
On the positive side were we to
ever find ourselves in a situation of great economic uncertainty, say
where the world’s financial institutions had pretty much bankrupted
everyone including sovereign nations, and the leaders of those nations
were unable to introduce the changes needed due to partisan politics,
then we should expect mean reversion to work quite well and quite
quickly. This would presumably be because markets weren’t doing their
efficient best anymore due to various factors, including a general
dearth of anyone with any money to take any risks with.
So just as soon as those
conditions come around we should be on the outlook for mean reverting
bargains. Can’t wait. Bound to happen some day.
So there you have it. Momentum
is dead and mean reversion is under suspicion, but is probably offering
decent returns for anyone with a surfeit of courage and a suitcase
stuffed full with cash. Yesterday’s sure-fire winner is tomorrow’s
dead-beat loser. That’s the fun thing about research into markets –
you’re never quite sure if you’re measuring eternal market fundamentals
or transient human behavior. It’s probably best to assume nothing works
for ever
--
Best Regards,
Jay Shah, FRM
Expect the unexpected!!!