Volume 19, No. 3, Third Quarter 2021

A New Index of the Business Cycle

by: William Kinlaw, Mark Kritzman and David Turkington

The authors introduce a new index of the business cycle that uses the Mahalanobis distance to measure the statistical similarity of current economic conditions with past episodes of recession and robust growth. Their approach has a key advantage compared to approaches that simply aggregate data, such as the Conference Board indexes, or approaches that rely on regression models. It considers the distribution of recession data separately from the distribution of growth data. This feature, along with the construction of the index as a relative probability, has the consequence of shifting the weights that are placed on the index inputs based on their prevailing values. In addition, their framework makes it possible to measure how the relative importance of the economic variables from which the index is constructed varies through time, which yields valuable insights about the dynamics of the business cycle.

Long-Run Implied Market Fundamentals: An Exploration

by: Heinz Zimmermann

The paper studies the volatility and correlation pattern of the fundamental valuation parameters (growth rate and its determinants, discount rate) calculated from widely used valuation ratios using the Gordon formula, and compares the findings to well-known insights from the asset pricing literature. Our results reveal a substantially different picture of the volatility and cyclicality of the implied valuation parameters compared to estimates from econometric models using historical returns. We argue, in the spirit of Campbell (2008), that implied Gordon parameters can be interpreted as empirical proxies for conditional steady-state market fundamentals, which is supported by our findings. The insights of this paper are therefore particularly challenging for investors with a long-term investment horizon who base their decisions on fundamental valuation factors.

On the Use of the Daily Fama–French Risk-Free Rate

by: Joshua C. Fairbanks, Mark D. Griffiths and Drew B. Winters

The Fama and French (1992) risk-free rate is used throughout the extant finance literature. The daily risk-free series has issues that raise concerns about its use as a benchmark. We detail the issues and discuss viable low-cost alternatives. We suggest the use of an adjusted one-year constant maturity rate for empirical analysis dating back to July 1, 1963. Our empirical results suggest that the choice matters in short-run analyses or single-day event studies, but not in studies that employ long-run averages, as is typical in asset-pricing research. We also document an interesting methodological division in empirical academic financial analysis.

Advances in Estimating Covariance Matrices

by: Jose Menchero and Lei Ji

Correlation matrices are widely used in finance both for risk forecasting and for portfolio optimization. It is well known that the sample correlation matrix is unreliable for portfolio optimization. However, we show that for purposes of predicting portfolio risk, the sample correlation matrix is close to optimal. In this paper, we present a technique for estimating correlations that is well suited both for risk forecasting and for portfolio optimization. We apply our technique to estimate factor correlation matrices spanning different asset classes. We find that our technique produces improved correlation estimates compared to an alternative widely used approach.

A Market Signal-Based Alternative to Buy-and-Hold Investing

by: Atanu Saha and Yong Xu

We propose a simple, hindsight-free, rule-based method of entry and exit into the stock market, with the goal of improving returns by averting large losses. Using data from 1928 through March 2020, we demonstrate that the proposed strategy delivers statistically significant outperformance over the S&P 500 total return index. Several robustness checks, including a Monte Carlo analysis, confirm the strategy’s outperformance in various sub-sample periods and investment horizons. These results hold after accounting for reasonable transaction costs for in and out trades. The strategy’s outperformance is explained by the non-normality and asymmetric persistence of market returns.

The Premonition

by: Michael Lewis • reviewed by: Javier Estrada

“Book Reviews” identifies important, and often popular, new books from a wide range of investment topics. Beyond providing a summary and review of the content and style of the books, “Book Reviews” seeks to contribute to a conscious, critical, and informed approach to investment literature.

Practitioner’s Digest • Vol. 19, No. 3

The “Practitioners Digest” emphasizes the practical significance of manuscripts featured in the “Insights” and “Articles” sections of the journal. Readers who are interested in extracting the practical value of an article, or who are simply looking for a summary, may look to this section.