Momentum is important because it may cause stock prices to deviate from the underlying fundamentals, as Graham alluded to in his pendulum analogy. High returns in the recent past may lure investors into performance-chasing out of complacency, greed or the often-mistaken belief that the past is prologue to the future. At the other end of the spectrum, low recent historical returns or market movements caused by triggered stop-losses may cause investors to sell near market bottoms out of anxiety or fear. In extreme cases, momentum may completely overwhelm the fundamentals, as was the case in the frenzied rise and subsequent fall in the prices of technology stocks during the Internet bubble from the late 1990s to early 2000.
In the short run, volatility begets more volatility. Complex statistical models are often used to measure this phenomenon. We chose to include the 30-day realized standard deviation of S&P 500 returns as our measure of volatility because of the long-term nature of its data series and the relative simplicity of its calculation and interpretation. By way of contrast, VIX relies on implied or estimated forward volatility, and its data series only goes back to the late 1980s, limiting its usefulness in longer-term analysis.
Volatility may beget volatility due to margin calls, crowd psychology and trend-following strategies like portfolio insurance. Volatility, like momentum, may also help explain why prices deviate from fundamentals. High levels of persistent volatility are generally reflective of anxiety or fear, while low levels may signify complacency or greed. But over long periods, volatility tends to revert to the mean. For example, the standard deviation of U.S. stock returns averages about 20 percent per year. Abnormally low or high periods of volatility are unlikely to persist for very long because the market ultimately recalibrates the relationship between risk and return.
High-Yield Bond Returns
Interest rates are an important macro indicator because they determine the cost of capital for nearly all individuals, businesses and governments. Theoretically, a rise in interest rates should result in a declining present value of future cash flows and lower asset prices. The base level of interest rates is largely determined by the U.S. Treasury curve. Credit spreads are added on top of U.S. Treasury (or other highly rated sovereign debt) rates in order to determine the appropriate yield to maturity or cost of debt capital for an issuer. When sentiment is low and risk is high, credit spreads widen. Credit spreads generally fall as economic fundamentals and sentiment improve.
We believe the returns on high-yield bonds represent a good measure of sentiment in the fixed-income markets because they often correspond to changes in the economy and interest rates. U.S. Treasurys can benefit from a “flight to quality” effect during times of market distress and may be artificially depressed when, for example, the Federal Reserve or other central bank is executing a quantitative easing policy. Also, during times of complacency and greed, credit standards often become lax. For these reasons, we view the returns on high-yield bonds as a “purer play” on interest rate and credit risk, and have included the Credit Suisse High Yield Bond Index as the fourth component of the AMSI. The Credit Suisse index was established in late 1985, and, we believe, provides an effective barometer of returns for this asset class.
Treasury Eurodollar (TED) Spread
We included the TED spread as a measure of systemic financial risk. The TED spread is based on the difference between the three-month Libor and the three-month U.S. Treasury bill interest rates. Banks serve as financial market conduits for nearly all businesses and governments through their capital-raising, market-making and savings activities. As we observed during the credit crisis, when banks have a problem, it ultimately becomes everyone’s problem because of their enormous global scale and substantial leverage.
Global financial intuitions today rely not only on customer deposits to fund their operations, but also on short-term loans from other banks. Therefore, if there is a crisis of confidence among banks, the TED spread is likely to expand dramatically. It historically ranges between 10 and 50 basis points, but it spiked to an astonishing 488 basis points around the time of the Lehman Brothers bankruptcy announcement. The TED spread also provides value to the AMSI outside of times of financial crises. For example, a less-than-dramatic rise in the TED spread may portend a credit crunch or slowdown in the economy. Therefore, we believe that the TED spread adds a unique measure of market sentiment to the index.