Man Group

Equity Trading: the Trouble with Value

Jamil Baz and Nicolas Le Roux

Abstract
Recently, liquidity-driven economic policies have mounted a challenge to time-series value
investing. In this paper, we examine the risk-return performance of simple value indicators.We
find that: 1) even though long term equity returns are partially predictable, directional value
investing delivers mediocre results; 2) the Central Bank put is a fly in the ointment for value
investors; 3) relative value has broadly outperformed absolute value. Lastly, we conjecture
that the poor performance of directional value investing hides substantial overvaluations in U.S.
equities.

December 7, 2015

Electronic copy available at: http://ssrn.com/abstract=2700691

Introduction
Graham and Dodd established the foundations for value investing in the 1930s. Value became
subsequently the favorite investment style for the patient investor. Recently, liquidity-driven macro
economic policies have mounted a challenge to directional value investing. In this paper, we examine
the risk-return performance of simple value indicators. We construct both directional and relative
value portfolios and proceed to list seven stylized facts about value investing.

Stylized Fact Number 1: Long Term Equity Returns Are

Partially Predictable
We test the predictive value of our signals: the cyclically-adjusted price to earning ratio
(CAPE), the current price to earning ratio (PE), the dividend yield and the replacement value
to market value ratio also known as Tobins Q. On a priori ground, all these indicators should matter: indeed, the inverse of the price to earning ratio, under some assumptions, is equal the real equity
yield (see appendix for a proof). All else being equal, an increase in the real yield of an asset should
cause excess demand for that asset and therefore higher expected asset returns. Similarly, the dividend yield is a reasonable approximation for the equity risk premium. A high dividend yield being
an indication of equity cheapness versus bonds, will also result in higher expected equity returns.
Lastly, the rationale for using Tobins Q as a value indicator is well known: as the market value of
a publicly-traded business drops below its replacement value, it pays to buy the stock rather than
building the equivalent business.
It is therefore comforting that some level of predictability of equity returns is borne out by the
data. In Figure 1, the regression of S&P 10-year returns between time t and time t + 10 against the
CAPE at time t shows that a high (low) CAPE predicts a low (high) equity return.

Figure 1. Regression CAPE vs. S&P Annualized 10-Year Returns

Electronic copy available at: http://ssrn.com/abstract=2700691

From Table 1, it can be seen that the R-square increases with the holding period: for the CAPE,
it is of order 4% for one year horizon and 34% for ten year horizon. Similarly, the PE, the dividend
yield and the Tobins Q predict equity returns with the R-square increasing with the holding period
in all cases.1
Table 1: OLS Estimates, Monthly Data

1yr

Beta
Cst
R Square
5yr
Beta
Cst
R Square
10yr
Beta
Cst
R Square
History from

Panel A: OLS Estimates

P/E
DivY
(0.22%)
2.24%
0.13
0.00
1.20%
3.24%
(0.49%)
10.20%
0.53
0.02
1.46%
15.95%
(4.21%)
14.51%
1.53
0.29
25.60%
19.19%
Jan 1901
Jan 1901

CAPE
(0.63%)
0.19
4.44%
(3.13%)
0.94
26.99%
(4.51%)
1.60
34.23%
Jan 1901

Tobins Q
(14.21%)
0.20
5.67%
(72.42%)
0.99
33.90%
(145.01%)
1.95
70.79%
Jan 1952

Stylized Fact Number 2: Regression Signals are not tradable

We now try our hand at trading the signals from the above regressions. To this end, we use
results from regressions with one year, five year and ten year returns over an expanding window. We
buy equity if equity returns implied by the regression are positive and sell equity otherwise. We scale
the size of the trading positions to the expected Sharpe ratio of the trade and rebalance monthly.2
In Table 2 Panel A, we show the empirical Sharpe ratios associated with the trading of our
four signals: the Sharpe ratios are all positive and comparable to the Sharpe ratio of a naive S&P
500 long only strategy. Interestingly, the skew of the trading strategies particularly for five year
and ten year regressions is improved compared to the long only trading rule (panel B).

1
But things are not that simple. The topic of equity return predictability has led to a long controversy. Boudoukh,
Richardson and Whitelaw (2006) show that when regressors such as the dividend yields are persistent, the estimators
are very highly correlated under the null hypothesis of no predictability. Under this same hypothesis, the betas and
R-squares are almost proportional to the horizon - which is exactly what transpires from Table 1. According to this
paper, at best, the use of multiple horizon regressions may be redundant; at worst, long horizon predictability is just
not there. Subsequently, Cochrane (2007) offers a defense of both short-term and long-term return predictability by
showing that dividend growth is not predictable. Ang and Bekaert (2007) find that returns are predicted by dividend
yields over shorter horizons but not over longer horizons.
2
The expected Sharpe ratio is calculated as the return predicted by the regression divided by the volatility of S&P
500 monthly returns over the most recent 12-month window

Table 2: Empirical Results for Regression Based Trading

Regression 1yr
Regression 5y
Regression 10yr
S&P long Only

P/E
0.44
0.60
0.67
0.50

Regression 1yr
Regression 5y
Regression 10yr
S&P long Only

P/E
-1.94
-0.28
-0.90
-0.95

Panel A: Sharpe Ratios

DivY
CAPE
0.33
0.33
0.52
0.49
0.63
0.62
0.50
0.50
Panel B: Skews
DivY
-0.56
0.29
-0.39
-0.95

CAPE
-0.81
0.56
0.17
-0.95

Tobins Q
0.18
0.36
0.37
0.70

Avg
0.32
0.50
0.57

Tobins Q
0.31
0.77
0.20
-0.78

Avg
-0.75
0.34
-0.23

While these results are interesting, major difficulties appear upon further inspection of the
data: first, if one uses, as we do, an expanding window to estimate the regression parameters, the
parameter estimates tend to move less and less as we add data points. The trading strategy becomes
stale to a certain extent: for example, using the signal from the ten year return regression against
the dividend yield, the strategy has been invariably long S&P 500 since 1962. Indeed, looking at the
regression equation in Figure 2, it would take a dividend yield of -1.97% to predict negative returns
over the next ten years. This simply means that estimates from a simple regression should not be
taken too seriously if only because when an index like the S&P 500 has a good run (as has largely
been the case since 1901), the regression simply extrapolates past good noise into the future. In
other words, the regression with many data points puts the trading strategy on automatic pilot.

Figure 2. Regression DivY vs. S&P 10-Years Returns

In an attempt to resolve this problem, we replace the expanding window with a twenty year
moving window. Here again, Sharpe ratios are comparable to a long-only strategy with no appreciable
reduction in skewness. This spells the need for a new trading rule.

Table 3: Empirical Results for Regression Based Trading (using a twenty year moving window)

Regression 1yr
Regression 5y
Regression 10yr
S&P long Only

P/E
0.52
0.54
0.59
0.53

Regression 1yr
Regression 5y
Regression 10yr
S&P long Only

P/E
-1.94
-0.28
-0.90
-0.95

Panel A: Sharpe Ratios

DivY
CAPE
0.55
0.53
0.59
0.56
0.62
0.58
0.53
0.53
Panel B: Skews
DivY
-0.56
0.29
-0.39
-0.95

CAPE
-0.81
0.56
0.17
-0.95

Tobins Q
-0.13
0.17
0.36
0.63

Avg
0.36
0.47
0.54

Tobins Q
0.31
0.77
0.20
-0.78

Avg
-0.75
0.34
-0.23

Stylized Fact Number 3: Rule-Based Trading Does not

Perform
To avoid the stale trading positions inherent to regression, we test a trading strategy based
on the z-score of the signals. We calculate the z-scores of the PE, the CAPE, the dividend yield
and the Tobins Q at each point of time by comparing the present signal value to the average value
from an expanding window, then normalized by the volatility of the signal. When the z-score thus
obtained is greater than one in absolute value, we trade the signal; otherwise, we do not and keep
a cash position. We test two strategies one binary where we either buy or sell one unit and one
linear where the trading size is proportional to the z-score. Note that, as in the regression case, the
strategy trades the mean reversion of the signals.
The results, summarized in Table 4, are quite disappointing as the strategy Sharpe ratio is not
significantly different from zero across all signals. Furthermore, it underperforms a long-only naive
strategy. We will revisit these results below (stylized fact 6).
Table 4: Empirical Results (Z-Score Strategy)

Z-Score (Binary, 1StDev)

Z-Score (Linear, 1StDev)
S&P long Only

Panel A: Sharpe Ratios

P/E
DivY
0.35
-0.12
0.15
-0.03
0.50
0.50

Z-Score (Binary, 1StDev)

Z-Score (Linear, 1StDev)
S&P long Only

P/E
0.92
-3.76
-0.95

Panel B: Skews
DivY
0.07
1.16
-0.95

CAPE
0.10
-0.01
0.50

Tobins Q
-0.53
-0.67
0.70

Avg
-0.05
-0.14

CAPE
0.42
-0.83
-0.95

Tobins Q
0.37
-0.78
-0.78

Avg
0.45
-1.05

Stylized Fact Number 4: Results are Similar in the US,

Europe and Japan
To make sure that our results are not U.S. specific, we compare results from regression-based
and ruled-based trading across a number of national stock indices: in the U.S., Japan, the UK,
Germany and France.
From Table 5, it appears that the negative relationship between PEs and subsequent returns
is broadly negative with a couple of minor exceptions. UK regressions fits surprisingly well, both in
terms of regression coefficients and R-squares.
Table 5: OLS Estimates for P/Es of Several Countries Equity Indices

1yr

Beta
Cst
R Square
5yr
Beta
Cst
R Square
10yr
Beta
Cst
R Square
History from

U.S.
(0.22%)
0.13
1.20%
(0.49%)
0.53
1.46%
(4.21%)
1.53
25.60%
Jan 1901

Panel A: OLS Estimates

Japan
UK
(0.02%)
(1.26%)
0.10
0.30
3.41%
15.38%
(0.07%)
(5.16%)
0.41
1.32
5.04%
43.50%
(0.16%)
(9.82%)
0.82
2.56
12.51%
86.99%
Jan 1956
Jan 1979

Germany
(0.14%)
0.12
0.33%
0.04%
0.49
0.01%
(1.84%)
1.36
14.64%
Jan 1969

France
(0.04%)
0.09
0.03%
0.64%
0.22
2.43%
(1.56%)
1.10
11.61%
Jul 1987

Sharpe ratios in Table 6 show insignificant to negative gains from trading the z-score whereas
regression-based (expanding window) trading broadly underperforms long-only trading, except in the
U.S.
Table 6: Empirical Results using P/E Indicator

Z-Score (Binary, 1StDev)

Z-Score (Linear, 1StDev)
Regression 1yr
Regression 5yr
Regression 10yr
Indices long Only

U.S.
0.35
0.15
0.44
0.60
0.67
0.50

Panel A: Sharpe ratios

Japan
UK
-0.37
-0.32
-0.26
-0.24
-0.06
0.56
0.21
0.43
0.28
0.68
0.43
0.69

Germany
0.27
0.16
0.42
0.26
0.44
0.52

France
-0.34
-0.12
0.13
0.11
0.50
0.43

Avg
-0.08
-0.06
0.30
0.32
0.51

Z-Score (Binary, 1StDev)

Z-Score (Linear, 1StDev)
Regression 1yr
Regression 5yr
Regression 10yr
Indices long Only

U.S.
0.92
-3.76
-1.94
-0.28
-0.90
-0.95

Panel B: Skews
Japan
UK
-0.86
-0.74
-0.70
-0.89
-3.71
-0.42
2.66
-0.84
2.64
0.03
-0.26
-0.93

Germany
1.07
0.91
0.49
-0.75
0.11
-0.85

France
-1.47
-1.10
-0.24
-0.44
0.09
-0.67

Avg
-0.22
-1.11
-1.16
0.07
0.40

Actually, all indicator (PE, dividend yield and CAPE) results are mediocre and underperform
the long-only strategy (see appendix).
How do our results agree with the widespread belief that equity value trading has been a
successful proposition? Our results are derived in a stock index, macro directional framework: indeed,
the results from a value trading strategy will be different in a single stock, relative value framework.
We will explore a relative value (cross-sectional) strategy later in this paper.

Stylized Fact Number 5: The Fed Put is the Fly in the

Ointment
So far, we have mostly reported (mediocre) results from trading value, but have not speculated
about the reasons for failure of value as an investment signal. Clearly, the prime candidate explanation is the relentless upward trend of stock prices throughout the data sample. But this trend is
hardly surprising: by looking at the US, we are looking at an order statistic. The US, after all, is
the best student in the class and this may be why all analysts keep studying the same data sample.
Indeed, if the stock market keeps rallying aggressively, even after indicators show it is fully valued,
then value trading will fail by construction.
Exactly when and why did US stocks continue performing despite value predictors pointing
otherwise? One can conjecture that this era of quasi-permanent expensiveness3 kicked off after the
Greenspan Fed nomination in 1987. One can also surmise that around that time, wealth-effect
became, although never officially, a prime target of Fed policy.
To check whether this was the case, we simply test our ruled-based trading strategies4 for
the periods before and after August 1987. The results are telling, to say the least: the strategy
results worsen for every single indicator after 1987 compared to the pre-Greenspan era. The average
difference in Sharpe ratios is a full 0.75. Surely, there are other explanations too. Two possible
explanations could be: 1) people figured out value trading was correct after a couple of decades of
Buffetts successful investing, and as more people traded value, the premium compressed and 2) risk
has decreased.

See stylized fact number 6

We do not compare the subsamples for regression-based trading: as mentioned, regressions yield overwhelming
long positions
4

Table 7: Pre and post Greenspan Comparison

Z-Score (Binary, 1StDev)

Z-Score (Linear, 1StDev
S&P long Only

Panel A: Sharpe ratios before 1986

P/E
DivY
CAPE
0.59
0.11
0.39
0.54
0.15
0.31
0.46
0.46
0.46

Tobins Q
-0.27
-0.43
0.75

Avg
0.20
0.14

Z-Score (Binary, 1StDev)

Z-Score (Linear, 1StDev
S&P long Only

Panel B: Sharpe ratios after 1986

P/E
DivY
CAPE
-0.23
-0.53
-0.56
-0.26
-0.47
-0.48
0.65
0.65
0.65

Tobins Q
-1.06
-1.04
0.65

Avg
-0.60
-0.56

Skew results are also worth reporting: not only does the skew of value strategies deteriorate in
the post-Greenspan era; the skew of the S&P returns deteriorates as well. To summarize, it would
appear that Fed policy is the most potent enemy of the directional value investor.

Z-Score (Binary, 1StDev)

Z-Score (Linear, 1StDev
S&P long Only

Panel C: Skew ratios before 1986

P/E
DivY
CAPE
1.53
-0.01
0.67
2.71
1.67
0.16
-0.86
-0.86
-0.86

Tobins Q
0.58
-0.02
0.27

Avg
0.69
1.13

Z-Score (Binary, 1StDev)

Z-Score (Linear, 1StDev
S&P long Only

Panel D: Skew ratios after 1986

P/E
DivY
CAPE
0.65
0.58
-0.02
-2.71
0.23
-1.11
-1.59
-1.59
-1.59

Tobins Q
-1.25
-1.69
-1.59

Avg
-0.01
-1.32

Stylized Fact Number 6: The Failure in the Value Factor

is Hiding Substantial Overvaluation
In light of the above, one may reasonably wonder whether central banks are not permanently devoted to
stimulating wealth; in other words, it may be that directional value investing is permanently doomed to failure.
Not quite so, we believe. It is likely that the failure of directional value over the last three decades is hiding
a structural overvaluation. Witness to that four standard value indicators: dividend yield, CAPE, Tobins Q and
market cap to GDP . We show below the time-series for each indicator including the last point and the average. We
also compute the indicators half-life, meaning the expected time it takes to travel half the distance to the average.
The results of the exercise are very clear: the US stock market appears to be overvalued by 57% to 102%
depending on the value indicator under consideration.

Figure 3. Dividend Yield Time-Series

Figure 4. CAPE Time-Series

Figure 5. Tobins Q Time-Series

10

Figure 6. Market Cap to GDP Time-Series

Table 8: Fair Values

DivY
CAPE
Tobins Q
Market Cap / GDP

Panel A: Fair Values

Current
Average
2.0%
4.1%
27.5
16.0
1.1
0.7
1.27
0.70

% Overvalued
102.0%
71.3%
57.1%
81.4%

Half-Life
3.9
7.5
6.2
5.7

Here, two remarks are in order: first, it is never comforting statistically to just rely on a limited data sample to
make sweeping inferences about value in the stock market. After all, it is well-known that the equity return estimate
is afflicted with a high standard error equal to T where is the market volatility and T the length of the sample. If
is 20% and T is 115 years, then the actual excess return could be 3.7% higher or lower than the point estimate from
the sample with a 95% probability confidence interval. Viewed from this perspective, a 115 year sample is too small;
second it can always be claimed that a historically stock market value is associated with lower risk.
While these two objections are perfectly valid, recall that we are dealing with the U.S. data sample: the U.S.
is an order statistic compared to other countries. If the current price is too high compared to the average historical
price and if that average historical price has beaten all average historical prices from other national samples, then the
presumption of expensiveness is even higher. And while it may be true that risk is lower today, the current context
macro-economic context where asset prices are subsidized by unsustainably stimulative policies and very high leverage
seems to dispel the notion of lower risk.
Also, we made implicitly the usual all else equal assumption (where all else was dividends, earnings moving
average, replacement costs and GDP) to infer the extent of the overvaluation. Things can get worse however. What
if all else is not equal? To take an example, the CAPE, as seen before, is 71% above average at unchanged earnings;
reversion to the mean would imply a fall of about 42% in the index value. But this assumes that earnings did not
adjust. If, as shown in the below graph, the earnings to GDP ratio reverses back to average, earnings should fall by
36% at constant GDP. Under these conditions, for the long term CAPE to adjust with both the numerator and the
denominator converging to the mean, stock prices should hence fall by 1 58% 64% = 63%.

11

Figure 7. Profit after Tax to GDP Time-Series

Stylized Fact Number 7: Relative Value Outperforms

Directional Value Trading
We now try our hand at one last trading simulation. If directional value investing does not work, what about
relative value investing?
To answer this question, we go long the three most valuable indices and short the three least valuable indices in
a universe of 25 national stock indices. The data sample starts in 1990. We rebalance on a daily basis. We then form
three portfolios ranked according to three indicators: price to book, dividend yield and price to earnings ratio. We
show in figure 23 the results of the simulation. The Sharpe ratio of the total portfolio is 0.54; interestingly, the skew is
positive and the beta of the strategy is negative. As a result, combining an S&P long position with the relative value
portfolio doubles the Sharpe ratio from 0.39 to 0.78 while taking the skew from negative to positive territory.
Of course, such a strategy will not stand on its own and should be part of a wider array of investments styles
within a broad portfolio. Relative value trading appears however to have desirable risk-return characteristics. Baz et
al. (2015) compare in more detail directional and cross section performances across asset classes.
Table 9: Relative Value Trading Results

Correl w. S&P
Sharpe
Skew (Daily)
Skew (50bds)

PB
(33.2%)
0.37
0.40
1.44

Avg
StDev
Sharpe
Skew (Daily)
Skew (50bds)

PB + S%P
6.2%
8.8%
0.71
0.21
0.94

Panel A: Signals Alone

DivY
P/E
(10.5%)
7.3%
0.47
0.02
0.47
0.87
0.88
0.26

CAPE
0.6%
0.09
0.76
1.80

Panel B: Combination
DivY + S%P
P/E + S%P
6.5%
2.6%
10.1%
11.1%
0.65
0.24
0.03
0.44
0.27
-0.64

All
(24.6%)
0.54
1.26
1.63

CAPE + S%P
4.1%
10.6%
0.39
0.18
0.43

S&P
100.0%
0.39
-0.24
-0.84

All + S%P
7.2%
9.2%
0.78
0.46
0.56

12

Conclusions
This paper finds that, even though long term equity returns are partially predictable, directional value investing
remains challenging. We show that the Central Bank put is a fly in the ointment for value investors. We also
find that relative value has broadly outperformed absolute value. Lastly, we conjecture that the poor performance of
directional value investing hides substantial overvaluations in U.S. equities.

References
1. Ang, A., and Bekaert, G. (2007). Stock Return Predictability: Is it There? Review of Financial Studies,
651-707
2. Baz, J., Granger, N., Harvey, C.R., Le Roux, N., and Rattray, S. (2015). Dissecting Investment Strategies in
the Cross Section and Time Series http://ssrn.com/abstract=2695101
3. Cochrane, J.H. (2008). The Dog That Did Not Bark: A Defense of Return Predictability. Review of Financial
Studies , 1533-1575
4. Boudoukh, J., Richardson, M., and Whitelaw, R.F. (2008). The Myth of Long-Horizon Predictability. Review
of Financial Studies , 1576-1605

13

Appendix
.1

Why the Real Equity Yield is equal to the Earnings Yields

A stock price P is the value of a dividend stream, with initial dividend D growing at a real rate g and discounted
at a real equity yield r.
Z
D
Degt ert dt =
(1)
P =
rg
0
It follows that r is:

D
+g
P
With R designating the real bond yield, the equity risk premium is:
r=

ERP = r R =

D
+gR
P

(2)

(3)

g, the real dividend growth, is equal to:

g = bi

(4)

where i is the real internal rate of return and b is the dividend retention rate (b = 1 D
E , where E is earnings). Firms
will keep investing until the real internal rate of return matches the real equity yield, hence i = r. We thus have :
P =
Therefore:

.2

D
D
E
=
=
r br
r(1 b)
r
E
=r
P

Regression and Back-Testing Results

Figure 8. Regression Table (DivY)

(5)

(6)

.2

Regression and Back-Testing Results

Figure 9. Sharpe Ratios (DivY)

Figure 10. Skew (DivY)

Figure 11. Regression Table (CAPE)

Figure 12. Sharpe Ratios (CAPE)

14

.2

Regression and Back-Testing Results

Figure 13. Skew (CAPE)

15