Rescaling The Obvious

 

Source: Shiller Data, JQR Capital

Earnings Yield Returns

Last week we glanced at the predictive power - as measured by the correlation coefficient - between earnings yield and stock returns. We see from the chart shown below that the predictive power appears to increase almost monotonically as we look further forward in our investment horizon. This again highlights the idea that over the long run, fundamentals (corporate earnings are about as fundamental as things get) matter the most to investment returns.


Source: Shiller Data, JQR Capital

Rescaling The Obvious 

The type of chart we display has an affect on our perception of this data. The previous chart is the bar style with an unscaled horizontal axis. This makes it seem like we want to hold our portfolio positions for 240 months - or 20 years - before hitting the rebalance button. Transaction costs (as measured by trading commissions) have recently dropped to near zero due to digitization and competition. We now change this lovely bar chart to a scatter plot which effectively rescales the investment horizon axis. This new view shows that the steepest part of the correlation trajectory is way over on the left hand side of this chart. This leads us to a new concept: rebalancing frequency.


Source: Shiller Data, JQR Capital

Introducing Information Ratio

During my time as a quantitative analyst at a Hartford equity hedge fund, we rebuilt our correlation models with new data every month. This made for one long night about every 30.44 days. We then reselected and rebalanced our 17 hedge funds every trading day. The reason for this vigilance was the idea of how many “at bats” a baseball player gets during a game, season, or career. By increasing the number of visits to the “plate” they have a much higher chance of making it to first base - even if their swing was always a bunt.


IR = IC * SQRT(BR)


The equation shown above introduces the information ratio (IR). It combines the product of the information coefficient (IC) and the square root of the market breadth. The IC is designed to measure analyst skill and can be thought of as the correlation coefficient in the chart shown above. Market breadth (BR) measures the number of investment “decisions” available to the analyst. These decisions - or at “bats” - are calculated by the number of assets available (2 in our case) by the number of rebalances per year. This is why more frequent - but highly-disciplined - portfolio rebalancing may actually be better for our long term wealth than a strategic asset allocation policy.


Next time we rewind slightly to discuss the VERY timely topic of interest rates and their influence on market behavior. Please stay tuned!

 

In the short run the market is a voting machine, but in the long run it is a weighing machine. - Benjamin Graham


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Disclaimer

Past performance is no guarantee of future results. Any investment involves some amount of risk and may not be suitable for all — or any — individuals. You should consult with your investment advisor before acting on this — or any — financial information.

References

http://www.econ.yale.edu/~shiller/data.htm

https://www.jqrcapital.com/channels/blog

https://www.brainyquote.com/


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Location: 23 Foxridge Rd, West Hartford, CT 06107, USA

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