Tactical Asset Allocation

Question 1

What is the earnings yield?

Answer 1

• The EY spread measures the total return from bonds minus total return on equities and is used to assess relative returns on bonds and equities
• Since equities have greater risk the expectation for this measure is negative and has averaged between -3% and -5%
• Low inflation recently has lowered the range.
• If the spread is zero or positve bonds would be the more attractive asset class offering higher returns at lower risk.
• If the EY is negative and widening this idicates increasing exposure to equities.
• In this way the EY is used as an asset allocation indicator.

Question 2

What are the merits of using the EY and what adjustments can be made?

Answer 2

• Merits:
  
  • The FED model has predicted 4 major turning points but the signal was not strong so investors are likely to have missed this signal.
  • For a given equity yield it can be used to identify zones of under and over valuations and to forecast possible forthcoming market adjustments.
  • Model assumes the partial predictability of stock returns, which many empirical studies confirm.
• Adjustments:
  
  • Cyclically:
    
    • Averaged over a 10-year period like the Shiller PE and measures the past 10 years of real company profits to the current market price.
    • Aims to look across the economic cylce.
    • Avoid shares looking expensive when profits collapse in a recession, and cheap when profits are at their peak.
  • Inflation:
    
    • Bond yields are nominal while profits have some inflation link so should have some control for inflation.

Question 3

What is the dividend yield spread?

Answer 3

• Spread = GRY - Dividend yield (Growth - risk premium through CAPM)
• If the DY spread is positive, the economy is likely to be in growth phase.
• If the DY spread is small and likely to expand, then equity growth rates will rise, or equity risks will fall, both are positve signs for equities.
• GRY of bonds is higher than dividend yield of equities as the latter would tend not to pay out all of its earnings as a dividend, preferring instead to reinvest some back into the company to grow.

Question 4

What is the term spread?

Answer 4

• Long GRY - Short GRY, so is the difference between the yields of long and short dates bonds.
• Often the 10 and 2 year is used.
• In a growth phase of the economy, an upward sloping yield curve is expected, so the spread will most likely be positve.
• At the onset of a recession, the measures tend to flatten and may even become negative as the yield curve inverts.
• The yield curve spread may be used to determine when a yield curve rise is most likely to be beneficial.

Question 5

What is the default spread?

Answer 5

• The difference between yields of investment grade bonds and gilts.
• In a good economy the default spread narrows.
• In a recession the spread will tend to widen.
• Can be used to predict a phase of the economic cycle from a market timing perspective.
• The spread measures the risk premium given the greater likelihood of defualt on the corporate bond.
• This also provides an idea of the marginal cost of funds to issuers with a similar credit rating.
• To the extend that the corporate bond is more illiquid then the gilt, the spread will also measure illiquidity risk. This makes it important to choose liquid issues in order to isolate the default risk.