Monday, June 27, 2022

Beware, but use investor sentiment to help with hard to value stocks


Investor sentiment, defined broadly, is a belief about future cash flows and investment risks that is not justified by the facts at hand. Sentiment has a market impact on longer-term fundamentally based investors because betting against sentimental investors can be costly and risky. Smart traders and arbitragers may not be able to offset the flows from sentiment in the short run. You can call sentiment traders, noise traders that introduce volatility associated with different use of information. Hence, sentiment can cause deviations from fair value. Some stocks will be more sensitive to sentiment than others, so sentiment can be incorporated in investment decisions. See "Investor Sentiment in the Stock Market"

Sentiment measures can either be top-down or bottom-up. Given our macro focus, we will discuss some top-down conclusions. Top-down sentiment focuses on aggregated reduced form measures.  Bottom-up sentiment uses or tries to measure investor biases. Some categories of stock are more sensitive to sentiment: low capitalization, younger, unprofitable, high-volatility, non-dividend paying stocks, growth stocks and firms in financial distress. Stocks that are harder to value or more difficult to arbitrage will be subject to more sentiment risk because investors will try and use other measure to form expectations and create a perceived edge. Sentiment is associated with the propensity of marginal investors to speculate on non-fundamental information.

High (low) sentiment will push speculative stocks above (below) fair value. Easy to arbitrage or value will have less variation from fair value based on sentiment. These speculative harder to arbitrage stocks will have higher (positive) sentiment beta while more bond-like stocks will have negative sentiment betas. As information is revealed, prices should move back to fundamentals. 

What can be used for macro sentiment:

  • Investor surveys - Consumer confidence correlates with small caps and stocks with strong retail interest.
  • Investor mood - Some researchers have found a mood associated with weather and daylight.
  • Retail investor trades - Retail investors herd and can push speculative stocks.
  • Mutual fund flows - Flows are often tied to retail sentiment and will drive speculative stocks.
  • Trading value - Volume changes represent differences in opinion and especially impact stocks when short selling is difficult.
  • Dividend premium - Given more "safe" bond-like returns, there will be a premium difference.
  • Closed-end discount - The deviation from net asset value can proxy for retail sentiment.
  • Option implied volatility - Option flow trading will impact volatility and describe speculative and hedge trading.
  • IPO first-day returns - Serves as a measure of speculative fever.
  • IPO volume - Bring new firms to market is based on perceived market optimism.
  • Equity issues over total new issues - A broad measure of equity financing activity. 
  • Insider trading - A measure of what corporate insiders think about their company.

These sentiment measures can be used in concert to form a sentiment indices which can measure the deviations from fair value of speculative stocks. Sentiment can proxy for speculative demand that may be reversed as new fundamental information is released. Positive sentiment can push prices higher and create volatility only to be reversed as news enters the market.

Sentiment may not be based on fundamentals, but it can play an important role for exploiting opportunities in hard to value (arbitrage) stocks. Sentiment in other asset classes that are hard to value can be employed to measure market extremes.  


Saturday, June 25, 2022

Credit spreads and equity levels


Credit investing and equity investing are closely aligned. A bond is a put on the firm. There is only a coupon return and the return of capital. If the firm value declines, there is a decline in the value of the bond. Equity is a call option in the residual value of the firm. Both are associated with the underlying value of the company. Hence, if overall equity values increase, the risk and spread for investment and high yield should decrease. If equity markets decrease, the residual value of the firm declines and the risk to bonds will be displayed in increasing bond spreads. 

We have taken a different look at this relationship through a scatterplot with a line tracking the relationship through time. It provides a different story for how this relationship moves through time and with the level of equities.

Using data from 2012 to June 24,2022, the pandemic dominates the relationship between equites and bonds. There was a credit crisis that far exceeded the equity downturn as measured by spreads. The current equity sell-off creates a similar credit spread pattern, but it seems muted relative to the past at least for investment grade bonds. 

The more interesting relationship is the shift of the trade-off as equity levels increase. Equity markets move and then credit risk adjusts to a new level. There is not just one equity-credit spread relationship.

Credit spreads and mean reversion - works well with trends


Credit spreads for both investment grade and high yield have been increasing with the decline in equity markets. These moves have been especially strong for junk bonds with low ratings. Investment grade have seen muted performance. High yield spreads are at the highest levels in five years if we extract the pandemic liquidity crisis of March 2020. The same can be said for investment grade. Trend-trading in credit is effective especially if it is conditional on the business cycle, equity prices, and financial stability. 

Within these long-term trends, there is also opportunities for mean-reversion strategies using a z-score methodology. If spreads widen by three standard deviations, there will be a spread tightening as new money tries to take advantage of higher spreads. The same can be said for the alternative of strong negative z-scores, however, this effect is weaker since it requires as selling of gains without a natural buyer. 

Investor who are buyers of extremes and hold for even a set time will be able to capture spread mean reversion. This mean reversion can be done in conjunction with trend trading to take advantage of macro and cross-asset changes as well as market extremes. 

Fixed income factor investing - Some evidence


Factor investing and analysis are a normal part of equity investing; however, it has not been generally implemented within the fixed income asset class. One, good data are harder to obtain and use. Two, the relative importance versus a benchmark has not been fully analyzed. Fidelity Investments in a white paper has started to do the empirical work and have provided some key insights. Apply simple factor definitions, they find suggestive outperformance especially for high yield bonds. Nevertheless, this work only scratches the surface and needs more careful work.

Using a simple value factor based on spread cheapness associated with a rating, it is found that both investment grade and high yield increase return to risk. The returns are high, but risk is increased so the next effect is limited. 

A tilt to the quality factor shows lower returns for both investment grade and high yield; however, there is also less risk. The net effect relative to a benchmark, at least for high yield is positive. Clearly, higher quality firms, lower leverage for example, show less return and risk.

The momentum effect is strong for high yield relative to investment grade. The dispersion of spreads as well as the opportunity for upgrade are greater for high yield so there is more potential return movement for junk bonds. 

The strongest effect is for low volatility. This is the well-known effect that low duration bonds have a better return to risk. The focus of many managers is in shorter maturity sector. 

The other strong factor effect is carry. High current yield will bonds provide more return and more cushion from interest rate changes. This is the case for investment grade bonds. High yield bonds with high carry have much higher risk than a benchmark.

When isolated for the interest rate macro factors, it is found that rate changes dominate bond returns, but if isolated as a floating rate note, credit spread changes dominate returns.