The development of core factor investing

 

First there was the CAPM factor which failed as researchers found that low beta stocks had higher returns and high beta stocks had lower returns than what would be expected with the CAPM model. It is a good theoretical model but its ability to explain cross-sectional returns is limited.

This led to the development of the Fama-French three factor model which included market risk, size (SMB) and value (HML) factors. This was a significant improvement and changed the way investors thought about risk.

From this framework Carhart added the momentum factor (UMD) or (MOM) which created the four-factor model. This now caused a significant amount of finance confusion. How can past performance predict or tell is something about relative returns" There is acceptance hat momentum is present in all assets classes and that is a fundamental risk factor albeit there is a still a view that this is a behavioral problem that should not exist. 

However, there was a desire to find more factors based on economic theory which were developed through the papers of Zhang et al. who found what were called q-factors which included operating profitability, ROE, and investment or a real investment factor or asset growth. 

Fama and French extended their 3-factor model to include operating profitability robust mins weak (RMW) which is measured by revenues COGS - interest expense SGA scaled by book value, and investment, conservative minus aggressive or CMA which is just asset growth scaled by total assets. This led to the quality factor as a key addition or for some a better interpretation of value.  

Since these core factor developments, there has been a zoo of factors to describe many risk premia. Many of these factors have not stood the test of time, but it shows that the search for return drivers is a dynamic and ongoing process. However, the core work of market risk, size, value, momentum, and quality are now the key factors for any discussion of equity returns.

Inflation - yes there was a transitory shock but ...

 

The discussion on inflation can be heated on whether the blame is with the Fed or is this just a tempest in a teapot about the transitory problem. There is no doubt that the pandemic with supply chain dislocations was a strong contributor to inflation. 

Claudia Sahm is one of the leaders of the transitory story and her case is strong, yet it seems like the last mile problem of getting to 2% is hard, and the slowing of inflation is not the same as reversing the inflation of the past. Prices are still high and that means if wages have not kept up with inflation, buying power has been diminished.

The question is not whether the Fed must hold rates higher for longer to slow demand and get inflation down to 2% but for how long. Since the transitory problem lasted longer than expected, we can also say that the rate rise will have to last longer than expected. Fiscal policy with deficits at 7% at full employment is a contributor that has yet to be offset. The conclusion is that the movement to normalcy is just going to be longer, yet the fear is that another shock will take us higher and not push us to target. The value judgment is that the Fed under-estimated the inflation lag structure.

Isaiah Berlin on freedom

 

"Freedom for the wolves often meant death to the sheep."

- Isaiah Berlin

Just a thought when you look at how universities are handling the protests on college campuses. The respect for all should be paramount at a university. The same thinking can be applied to other issues both on the right and left. 

While we want to maximize freedom, there are levels where the freedom of some places a tyranny on others. We would like society norms of respect to control excesses but that is not always the case. 

Cash is king, again? And stocks are overvalued

 

There is the image of old ladies and retires holding their dividend paying stocks as way to meet expenses. This should always be a good value; however, if you look at cash rates for T-bills there is not comparison. Sell those stocks and hold the risk-free rate at 5.25%. It makes even more sense if they're not going to be any Fed action in 2024. Get risky and go out a year or two and you still will do better than those dividend paying stocks. The only reason for holding stocks if you assume there will be positive gains that will make up for the rate shortfall. On a risk-adjusted basis, you should assume that this number will be greater than the rate difference. You should assume a volatility drag when calculating the geometric mean. 

This discussion does not even discuss the ratio of cash to dividends as a valuation indicator. We are at 2000 tech bubble levels and well beyond anything seen in 2008.