Technically not Passive

A look at investment strategies that my professors would have failed me for, but upon further review appear to earn passing grades

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    Markets are crazy hard to beat.  Indeed , I think the vast vast majority of people should not try.  Rather be largely passive.  However, passive need not mean dead and some gentle nudges and meanderings away from a strict market value based index is probably a good move.  

    For instance, value investing has a long track record of outperforming in a risk-adjusted basis. And following a period of very high P/E ratios, returns tend to be lower.  Additionally, momentum (serial autocorrelations) seem to be important enough to account for in pushing the portfolio a bit one way or another. 

    The basic idea is then to invest passively but with minor modifications to capture slightly higher returns or (and more likely) lower expected volatility.  This sort of passive investing model is what is behind the many ETFs and "Smart Beta" portfolios that try to take advantage of the newer findings. 

    So this path attempts to bring some of the findings of markets being less than perfect together with the core idea of passive indexing.   

    For my Investments and SIMM (the Student in Money Management) courses at St. Bonaventure University), this path will be course material and will be tested.  For the rest of you, I hope it helps but remember past performance does not guarantee future results, and I am a professor and NOT AN INVESTMENT PROFESSIONAL (YOU HAVE BEEN WARNED).  :) 

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    How to measure momentum?

    Proponents of momentum investing basically suggest that in the "near term"  (a term that itself is open to various interpretations) assets that are going up, will continue to go up.  (more technically this is called positive serial correlation). 

    Given finance is a big field and no two people do things exactly alike, how to exactly measure momentum is up for debate.  For instance, some believe that looking at how close to the 52 week high is a measure of momentum.  Many others use various technical indicators.  These include moving averages (based on an almost limitless number of days--200 day is common), momentum and MACD ratios.  

    I would not get too hung up on the exact differences to start.  For instance, who (besides academics) cares if a 200 day or a ten-month moving average is used?  

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    Timing Model - Meb Faber Research - Stock Market and Investing Blog

    If you have kindle or not, I HIGHLY suggest you read his free ebooks. Good stuff that will stick with you way after you leave this class. But for now, at least read his paper on asset allocation. "The timing model I published in 2006 can be found here complete with 2008 updates: " A Quantitative Approach To Tactical Asset Allocation " FAQ follows at the end of the post. Charts below from the good folks at RightWayCharts: I try to be as open and honest about the benefits as well as the drawbacks of every strategy and approach I research."

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    Yes, Crossing The 200 Day Moving Average Is A Big Deal

    One of the quick-and-dirty tools used to technical analysts is to see where a stock or index is compared with its average price over the past 200 days. This is an easy way to get a read of a stock's momentum. Yesterday was a big day for the 200DMA world.

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    Understanding Technical Indicators - MACD and DMI Part 1

    Dave Rakus traditionally speaks in SIMM a few times a year. MACD is by far his favorite indicator, but he is also a fan of moving averages. "This webinar will introduce you to technical indicators , explains why you should use technical indicators, the difference between leading and lagging indicators and then takes an more in depth look at Moving Average Convergence Divergence (MACD) indicators and Directional Movement Index (DMI) Indicators."

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    Three-Way Model - Meb Faber Research - Stock Market and Investing Blog

    As Dave Rackus is apt to say--"the trend can be your friend". From Meb Feber: "My readers know I am a trendfollower at heart.....Three asset classes: Stocks, bonds, gold. Invest equally in whatever is going up (defined as 3 month SMA > 10 month SMA). That’s it. Thumps the stock market with less risk - See more at:

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    Price Earnings as a predictor

    Sometimes things matter that should not matter.  If one believes in the market is semi-strong form efficient (all public data is incorporated into price), then PE ratios which are hugely public, should already be priced and thus future returns should be unrelated to the current PE ratio.  

    Alas, much research now shows that PE ratios do predict future returns.  More specifically, when the market pays much for a dollar of earnings (high PE) the future returns are low (and vice versa).  

    I am not smart enough to know why this is true, but it appears that there is some mean reversion going on.  This is LIKELY caused by periodic over and under pricing.  Thus, while the market is correctly priced on average, it may be high or low at any given point.

    The next few links show some of this evidence.  

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    PE Ratio and Stock Market Performance by Shen

    "...historical evidence that very high price-earnings ratios have usually been followed by poor stock market performance. When price-earnings ratios have been high, stock prices have usually grown slowly in the following decade. Moreover, at times such as the present when high price-earnings ratios have reduced the earnings yield on stocks relative to interest rates, stock prices have also tended to grow slowly in the short run. Forecasts based on such evidence are subject to much uncertainty,"

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    Price Earnings Ratios as Forecasters of Returns

    Posted 7/21/96 Price-Earnings Ratios as Forecasters of Returns: The Stock Market Outlook in 1996 by Robert J.

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    P/E 10 Ratio Definition | Investopedia

    CAPE or PE 10 or Shiller PE are all ways of smoothing out the E in PE ratios over a longer window. From Investopedia: "A valuation measure, generally applied to broad equity indices, that uses real per-share earnings over a 10-year period. The P/E 10 ratio uses smoothed real earnings to eliminate the fluctuations in net income caused by variations in profit margins over a typical business cycle."

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    A low value for the ratio that is below 15 or so can either indicate a good buy or a bad one depending on other factors. Strictly speaking a low value indicates a current stock price that is comparatively low compared to its earnings history.

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    Vanguard's look at what does and what does not help predict future stock prices

    "We confirm that valuation metrics such as price/earnings ratios, or P/Es, have had an inverse or mean-reverting relationship with future stock market returns, although it has only been meaningful at long horizons and, even then, P/E ratios have “explained” only about 40% of the time variation in net-of-inflation returns. Our results are similar whether or not trailing earnings are smoothed or cyclically adjusted (as is done in Robert Shiller’s popular P/E ratio)."

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    Value investing

    Value investing is usually described as investing in companies with low market prices relative to some other variable.  For instance, Price to book ratio, TOBIN's Q, and even Price to earnings are a few of the ratios used. 

    The evidence here suggests that value stocks earn a higher return moving forwars. 

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    Warren Buffett On Value Investing-CNBC

    Warren Buffett talks about value investing with Columbia Business School students

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    What is Value Investing?

    What is Value Investing? It is basically a set of tenets introduced by Graham when he wrote Security Analysis in 1934. Fundamentally, value investing involves buying stocks that are out-of-favor in the market due to investor irrationality. This irrationality, in the extreme, can often push a stock's price well below its true value.

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    Danny DeVito Explaining Value Investing -- Benjamin Graham Style (Other People's Money)

    Danny DeVito does a valuation analysis on a company. BTW if you have never watched Other's People Money, do so! Great for finance classes even if it is now quite dated.

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    So what does this all mean?

    While I do largely believe in market efficiency, I acknowledge it is not perfect.  And investors are not perfect.  So as a result, I believe in watching costs, avoiding excessive trading, assuring risk management through diversification, not trying to make huge bets on market timing, and doing your best to minimize taxes.  BUT maybe some rebalancing and screening at the periphery of the portfolio.  

    For instance, X% in various indexes (stock and fixed income), and then the remainder of the portfolio in value/momentum funds/commodity funds rebalanced maybe once a year or so. 

    I will NEVER give more specific recommendations and links included are not recommendations, but just examples of funds that could be used.

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    A Different Dimension

    READ THIS ONE! Probably the closest to my view as anything I have seen. I heard Booth speak a few years at a conference and was hooked. More Mutual Fund Quarterly Stories It was 7:30 on a sunny October morning in Austin, Texas, and class was about to start. Most students were finishing their coffee and chatting about how they were looking forward to hearing professor Eugene Fama, the University of Chicago economist who a week earlier had won the Nobel Prize.

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    More on Cambria's 'Global Asset Allocation ETF'

    Mebane Faber, CIO of Cambria Investment Management, introduces the firm's newly launched exchange-traded fund (ETF) on the Nasdaq, which has no management fee.

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    Fact, Fiction, and Momentum Investing

    By Clifford S. Asness, Andrea Frazzini, Ronen Israel and Tobias J. Moskowitz " We highlight ten myths about momentum and refute them, using results from widely circulated academic papers and analysis from the simplest and best publicly available data."

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    Beat the Market with Momentum ETFs

    Buy high and sell higher--the mantra behind momentum investing works pretty well in the short run.

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    SYLD Investment Case

    Free cash flow has long been emphasized by investors as a key predictor of a company's strength. Companies that pay cash dividends, one indication of strong free cash flow, have historically outperformed the broader market. Focusing strictly on dividend payments, however, misses two key indicators of strong free cash flow: net share repurchases and net debt paydown.

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    Wrapping up

    I guess this is a passive aggressive model.   Markets are very tough to beat and frankly I do not think it is worthwhile trying for the VAST majority of people (myself included).  

    Passive investing is growing significantly and this is a very good thing.  Indeed, if I only have time to teach one thing in an investment allocation setting, passive wins would be it. 

    However, academic and Wall Street research suggests that this first pass optimum model can be improved by fine-tuning the now largely passive portfolio to be a bit better. 

    If you want more on this topic, let me suggest listening to the Masters in Business Podcasts of the following:

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