My firm, AthenaInvest, has conducted extensive research on the use of behavioral factors to estimate expected returns and, in turn, to make market-rotation and beta-exposure investment decisions. The research results are compelling. The following article outlines our behavioral approach and compares the results to a passive benchmark.

Deep behavioral currents

Aggregate stock market returns are driven by the collective buy and sell decisions of individual and institutional investors. Many market factors enter into investor decisions, with the relative importance of each factor evolving over time. At times investors will place more importance on economy-wide data, at other times on stock market activity, and at other times on the relative attractiveness of industry sectors or even on specific stock information. I refer to these as the deep behavioral currents driving market returns.

The ever-changing relative importance of these currents is a major determinant of market returns. Sometimes this mixture is more favorable and thus expected returns are higher. At other times the mix is less favorable, resulting in lower expected returns. When estimating market-expected returns, it is important to know the mix of currents flowing through the market.

Active equity mutual fund managers provide the framework for generating a snapshot of this mix. Different groups of active equity managers use different strategies to analyze, buy and sell stocks. For example, valuation managers hold stocks driven by value-oriented return factors such as low PE, while future growth managers hold stocks driven by factors such as earnings growth and high R&D.

For the last 10 years, AthenaInvest has collected thousands of pieces of strategy information on U.S. and International active equity mutual funds and, based on this information, placed each fund into one of 10 strategy clusters. This clustering provides an intelligent organization of the myriad investor decisions driving overall market returns.

Once the equity fund universe was organized in this way, our focus turned to how investors are responding to each strategy – specifically, the preference, captured by ranking recent strategy returns, for one strategy relative to another is estimated.

We compared recent strategy performance ranks to long-term ranks and calculated three market barometers: U.S., international, and capitalization. Our research revealed that an alignment of recent ranks with long-term ranks is predictive of higher expected returns in that market, while a lack of alignment is indicative of lower returns.

Figure 1: Relationship between strategy ranks and expected market returns

Behavioral Factors Tactical Management

Figure 1 provides a graphical representation of the relationship between strategy ranks and expected market returns. If current strategy ranks align with long-term ranks, then expected returns are high. This means investors are currently rewarding strategies in the same way they have performed over the long run. More specifically, investors are driving up prices of the stocks held by future growth and competitive position funds relative to the stocks held by other strategies. This is a positive sign for the market and leads to expected returns well above the 10% long term average.

On the other hand, if ranks are inverted in relationship to long-term ranks, investors are driving down future growth and competitive position stock prices relative to risk, social considerations, economic conditions and market conditions stock prices. These four are historically weaker strategies. This is a bad sign for the market and indicates investors are taking a defensive position rather than focusing on long-term stock market drivers. As a result, the expected market return is weak or even negative. For example, social considerations, risk, and market conditions were top relative strategies in 2008, a bad sign for the market. And we know what happened in 2008.

When strategy ranks fall somewhere in between aligned and inverted, a mixed situation exists and the expected market return is somewhere around the long-term nominal average of 10%.

To be clear, market barometers differ from technical concepts such as momentum and mean reversion, which are often used for predicting future market returns. Barometers focus on relative strategy performance, rather than on whether recent returns have been positive or negative. It is possible for a barometer to be high or low regardless of recent market performance. Empirical tests confirmed that barometer predictions are independent of trailing six- and 12-month market returns and are thus capturing something other than momentum or mean reversion.

Additionally, they are not a measure of market sentiment, but instead capture actual investor behavior. Strategy ranks are the result of collective investor activity, so they reflect what investors do and not just how they feel about current market conditions. Thus they are a “put your money where your mouth is” metric.

For a complete methodology description see here and for a robust empirical test see here.

By C. Thomas Howard, PhD, read the full article here.