A New Approach for Forecasting Market Returns

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Investors are showered with stock market predictions addressing the ever-present question of where the market is headed.

Many of these forecasts are based on historical price and volume data and use concepts such as overbought and oversold. Others use economic and market data to ascertain where the market is headed based on the current state of the economy. Still others try to gauge market sentiment by surveying investors to determine if they are more bullish or bearish.

I propose an alternative method for predicting future market movements, which I call the strategy market barometer (SMB). The SMB is calculated by measuring the extent to which investors are rewarding specific investment strategies being pursued by active equity managers. My research reveals that equity strategy performance ranking is a useful predictor of future market returns, and tests confirm that market returns vary in line with SMB measurements.

Equity strategies capture which factors are driving market returns

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, and the relative importance of each factor evolves over time. At various times, investors will place more importance on economy-wide data, stock market activity or specific industry sectors or stocks.

When estimating overall market expected returns, it is important to know the current mixture of factors operating in the market.  AthenaInvest identified 10 equity strategies that active equity managers pursue to generate superior returns. Each strategy represents a set of market factors. For example, competitive position (CP) managers might focus on innovative companies, building an investment process around factors such as strong management and defensible market positions.

A strategy’s performance rank relative to the other strategies varies over time because investors collectively focus on a changing mix of strategies and market factors. However, investment managers usually pursue their investment strategies regardless of whether they are in favor with investors or not. Managers keep doing the same thing while investors change their focus, which provides a stable prism for viewing what is being favored by investors at a given time.