The S&P 500 broke free of its recent mean-reversionary tendencies and charged upward to a new all-time high of 2096.99. Queue the balloons and tickertape: it’s time to party like it’s 1999!
Now some may remember how partying in 1999 turned out (hint: not well). While the deepest troughs of sorrow have typically follow peaks of exuberance – like stocks in 1929 and 1999 or the housing market in 2007 – it turns out that they tend to be the exception, and not the rule. Based on historical data from 1900, the probability that a market high is followed by a 3-year positive return has been 71% – with an average return of 22%.
In fact, 52-week highs (which, by definition, are a superset of all-time highs) are a well-studied phenomenon. A quick summary:
A study performed at CXO Advisory finds that weekly returns during the quarter after a 52-week high tend to be positive and placid.
In Industry Information and the 52-Week High Effect, Hong, Jordan and Liu show that buying industry groups whose stocks are near 52-week highs and selling those near 52-week lows creates robust and consistent positive return – with the contribution from the long-side being twice as large as that from the short-side.
In The 52-Week High and Momentum Investing, George and Hwang find that nearness to the 52-week high is comparable to other momentum indicators in forecasting returns and that a 52-week high momentum strategy generates risk- adjusted returns about twice as large as traditional momentum strategies and the returns do not reverse over the long run like traditional momentum strategies.
We will quote George and Hwang for a potential theoretical underpinning of this phenomenon:
“Traders appear to use the 52-week high as a reference point against which they evaluate the potential impact of news. When good news has pushed a stock’s price near or to a new 52-week high, traders are reluctant to bid the price of the stock higher even if the information warrants it. The information eventually prevails and the price moves up, resulting in a continuation.
Similarly, when bad news pushes a stock’s price far from its 52-week high, traders are initially unwilling to sell the stock at prices that are as low as the information implies. The information eventually prevails and the price falls. In this respect, traders’ reluctance to revise their priors is price- level dependent. The greatest reluctance is at price levels nearest and farthest from the stock’s 52-week high. At prices that are neither near nor far from the 52-week high, priors adjust more quickly and there is no pronounced predictability when information arrives.”
Empirical and theoretical evidence for smooth sailing is strong. That is, until Robert Shiller – economist at Yale University – comes along and deflated our enthusiasm with a single tweet:
For the uninitiated, the Cyclically Adjusted Price Earnings – or CAPE – is a price-to-earnings measure for the S&P 500 based on average inflation-adjusted earnings over the prior decade, which helps smooth out short-term earnings volatility and medium-term business cycle gyrations.
With valuations making highs (though, still not at the nosebleed CAPE 44 levels of the dot-com boom), forward return expectations are muted. For the cynical, the forecast is downright nasty. Like, recent Boston weather nasty.
Ignoring arguments about whether the current global economic landscape provides an exception to the usual rules (I think Josh Brown did an excellent job in his blog hitting the major points last year), it appears we have a conflict: momentum says onward and upward and valuation says “not so fast.”
But they may not be at odds. We have to remember that momentum is a short-term phenomenon whereas valuation is a long-term forecast tool. A high CAPE figure forecasts a low annualized return over the next decade and speaks nothing to the next month or quarter. We can be onward and upward in the short-term and not violate the larger mean-reversion forecasted by CAPE.
It is also worth pointing out that while momentum speaks specifically of returns, CAPE has two components: price and earnings. While a price sell-off is one way for CAPE to fall back to “normal” levels, another way is for earnings growth to outpace price return.
Momentum and valuation are not at odds here: they’re just not talking about the same things.
In Our Models
We rebalanced our Multi-Asset Income portfolio this week, increasing our position in emerging market sovereign debt and decreasing our position in U.S. corporate bonds. While emerging market debt has been largely range-bound since May 2014 (with a large sell-off in December), recent price strength has led to a consistent momentum signal. Based on risk-adjusted yield, preferreds and mortgage REITs remain favored by our models, followed by U.S. corporates and then emerging market debt. In combination, those 4 positions make up over 75% of the portfolio’s composition.
While the portfolio remains concentrated in those 4 positions, the current weighted portfolio cross- correlation sits at only 34.79%, highlighting the incredibly diversified nature of these holdings against each other.
In the equity space, as markets break upwards and out from their recent range-bound behavior, the downside buffer to cash grows. In our Risk Managed Global Sectors portfolio, we estimate a downside buffer of approximately 7%, indicating that global markets would have to broadly sell off by that much before our momentum signals would build a short-term U.S. Treasury position within the portfolio.
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