Using Factor Investing To Tame Financial Chaos

21st Dec '22 by Alex Naamani

7 comments 4563 reads

Let’s suppose there are two types of economists. The first type thinks stocks behave in a predictable, orderly way. They treat stock selection as a ‘science’, rather than an ‘art’, and try to identify factors that drive stocks up or down according to a clearly defined formula. The second type thinks price trends are chaotic, even random, while stock picking is a matter of good luck.

Nassim Taleb, author of Fooled By Randomness, arguably falls into the second group of economists. When asked to explain the success of Warren Buffett, Taleb said that if you gave every person in America a coin and awarded them $1 whenever they flipped heads, some people would inevitably become rich, albeit by chance. At the other end of the spectrum are economists like Ray Dalio, Eugene Fama and Kenneth French. Their models strive to identify patterns within the chaos of financial markets. Dalio’s research looks at the relationship between stock returns and interest rates. Fama and French suggest investors can potentially predict price trends by looking at company-specific factors. Have their methods cracked the mystery of the stock market? Let’s take a closer look…

A paradigm of Platonicity?

Ray Dalio, founder of Bridgewater Associates, sees stock market complexity as something that can be understood with the right analytical framework. His studies divide history into periods, or paradigms. Within each paradigm, stock prices are driven by a particular set of market forces, for example, low interest rates, stock buybacks, tax cuts and wide profit margins since 2009. Dalio’s approach is elegant, but someone like Nassim Taleb could insist that Dalio is a victim of ‘Platonicity’ - i.e. the naive desire to cut reality into neatly defined shapes that ignore underlying complexities and nuances.

Is Dalio’s approach simplistic? Let’s explore. Dalio says that since 2009, we have been in the paradigm of ‘Reflation’, where central banks drove stock prices up by pushing interest rates down. This makes intuitive sense. When the central bank rate is lower, interest rates fall across the economy. Stocks become more attractive if returns from dividends and price appreciation exceed returns on cash savings. That’s the theory, but does theory reflect reality? Consider the following Financial Times headline:

GLOBAL STOCKS KNOCKED AFTER CENTRAL BANKS PUSH INTEREST RATES HIGHER

There we have it! Dalio was right, or was he? Maybe it’s not that simple. The following chart shows how the FTSE 100 responded…

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colin1862

21st Dec '22

All good stuff. Would the conclusions be the same if you subdivided into Size categories? or even just removing microcaps

Epitychia

There is an interesting paradox. Random stock returns implies an extremely well ordered efficient system of share pricing. Price adjustments level the playing field. Bumps in the playing field imply errors in human analysis and execution. In a sense the stock market is the least random system in existence.

BnB

I'm enjoying the references to existentialism but your argument lost me when you used the FTSE100 to represent the typical index. The footsie is an anachronism, not a paradigm.

andrewdb

you are reiterating some of the reasons that SNAPs generally outperform (as long as the underlying SR outperforms).

All good stuff and worth driving home .

As others have noted, would be good to understand the impact of further constraints, such as

Size
Yield
F Score

and how the number of stocks chosen affects the outcome

DWit199

I keep my own database and I have been able to explore the relationship between various factors and stock returns. My investment universe is just over 800 shares in size. I took the top and bottom 100 by StockRank (top SR approx>90 bottom <20) 6 weeks ago and sorted the total returns over the following 6 weeks for each 100 into descending order. These were then plotted on the bar chart below. The mean 6 week return was 2.2% for the top 100 and -3.2% for the bottom 100. There are some big winners and losers in both groups. More of the low stockrank shares were losers. Interestingly, the spread of outcomes is much greater for the lower ranked stocks.

Charles Skinner

Need to look at longer term cycles. Credit Suisse paper of May 22 based on all markets back to 1900 was pretty unequivocal, particularly for that sort of paper:

Historically, the returns on stocks and bonds
have been much lower during hiking than easing
cycles. Indeed, Dimson, Marsh and Staunton
(2016) report that during hiking cycles, it has
historically been hard to identify assets that
perform well. On average, periods of interest
rate rises have been accompanied by inferior
industry returns, smaller rewards from many
factor investing strategies, and lower price
appreciation for a wide variety of real assets.

There's nowhere to hide. I'd say "tin hats on" but there aren't any tin hats. For those of the lucky demographic, just spend the money made from 1982 (interest rates 14%) to 2021 (interest rates 0%).

Alex Naamani

22nd Dec '22

Hi Charles,

You are right.

Over the longer-run, periods of higher interest rates probably see lower stock market returns. However, over a shorter period, the relationship between rate hikes and stock returns is less clear cut (at least if we look at UK data between 2009-22). So I guess it depends on someone's investment horizon. Someone who has decided, rightly or wrongly, to be in stocks for the next few years may choose to treat rate hikes as noise, rather than signal.

To your point about 'tin hats' and there being nowhere to hide, I guess it's worth considering this: high StockRank stocks did indeed have a tough time in 2022, but lower StockRank stocks had an even tougher time. They generated even lower returns. So again, if someone has decided for whatever reason to be in stocks, then factor investing could be a useful tool that can be used to protect/preserve wealth.

Using factor investing to tame financial chaos

A paradigm of Platonicity?

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Alex Naamani

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