There is no equity risk premium!

There are several ways of measuring the equity risk premium. The above chart is a simple approach, and it shows the premium is at levels not seen since the dot-com bubble. Other approaches may show the premium slightly higher, but all are signaling that we are are at low levels which suggests that forward returns are likely to be lower.  

This is not saying returns will be negative in the next year nor does it say we will have a crash. It is saying that your long-term allocation to stocks is unlikely to generate returns similar to what were present over the post-COVID period. 

Replicating trend-following beta is achievable

 

Trend-following strategies have proved to add significant value to a portfolio, but there is a problem - what model or managers should I use to represent my trend exposure? This issue is discussed in the paper, "In pursuit of trend-following beta: The promise and pitfalls of replication".

Building your own trend model will have problem because here is a wide dispersion in the performance of different trend strategies. How do you pick the best strategy. However, there also is a problem if you want to pick specific managers.  There is wide dispersion across managers. The alternative is to hold an index or attempt to replicate a well-defined index like the BTOP50; however, any replication scheme has issues. One choice is to form a portfolio of managers, but there are ongoing costs with this fund of funds structure. An investor may be able to cut costs with forming a portfolio strategy replication; however, there may be skill leakage. You will not be able to capitalize on the stronger behavior of better managers.

The authors conduct a useful exercise on how to develop a replication strategy using a limited number of markets and simple OLS regression or LASSO regression. While not perfect, the cost savings with careful regression work can add value relative to a trend-following benchmark (more precisely a portfolio of CTA that are mainly trend-followers). My experience suggests that replication is not always easy. There are operational costs that can be high if there is not scale, but the idea of forming a cheaper replication of a manager bundle is useful and can add serve as an alternative to picking a bundle of managers.

VIX and corporate bonds

 

There is risk in corporate bonds and this risk can be measured through the VIX market. Equity and bond markets are linked. This should not be surprising since the corporate structure can be divided in equity - the residual value of the firm which is call option and bonds which are a short put option on the firm value. A change in volatility will lead to a change in the value of these options. If the VIX serves as a proxy for equity volatility, then there should be a link with bond spreads which are the added risk above Treasuries for holding corporate bonds.

The authors of an early draft paper, "The VIX as Stochastic Volatility for Corporate Bonds" show that adding the VIX to a time series model of corporate spreads will improve the time series model. First, the residuals of corporate bonds spreads are not Gaussian white noise; however, if you scale the residuals by the VIX to standardize, you will get an improved model. The spikes in spread are dampened when they are scaled by equity market volatility. This is a simple model and test, but it serves as an important improvement over looking at just the simple time series of spreads.

The economic of information - a history which leads to narrative information

 

The economics of information have made many advancements since the theory of market efficiency. The current direction of information economics is to link narrative economics with market sentiment and returns. This chart is from Ronnie Sadka of Boston College from his work with State Street on market narratives. There are several media-driven reservoirs that can be used to generate narrative information. There is information intensity as well as news sentiment. Once we have isolated information, we can look at dispersion, disagreement, and content. From the narrative information portfolios can be formed with narrative sensitivity. 

Ways of thinking about news narrative that can be quantified.