25 July 2017

The Rewards of Being Sentimental: +250% Over the Last 5 Years

My dearest stock – “Sentiment” in equity markets isn’t that much emotional but it could prove nonetheless rewarding. The term was coined to describe a combination of equity research indicators – initially selected by JP Morgan – designed to capture market dynamics with growing interest from sell-side analysts.

Sismo is the perfect visual analytics tool to immediately identify stocks exhibiting such characteristics as a strong increase in target price (over the last 6 months), a positive change in analysts’ buy recommendation (over the last 3 months) and strong current buy recommendation expressed in percentage (i.e. % of analysts covering the stocks with a buy recommendation).

Applied to the Stoxx 600 Europe constituents as at 14 July 2017, a double-quartile screening on such criteria highlights the positive “sentiment” score of certain stocks, like steel and aluminium producers (Arcelor Mittal, Outokumpu, ThyssenKrup, NorskHydro) and other mineral resources companies (Glencore, Rio Tinto). On the opposite, telecom stocks score poorly, exhibiting negative market interest dynamics.

Stoxx 600 Sentiment Analysis at 14 July 2017 – Telecom stocks highlighted with white borders

Double-quartile visual, a reading guide

The Sismo screen above visually conveys the whole “sentiment” information on the constituents of the Stoxx Europe 600 as at 14 July 2017. It should be read as follows:

  • Each stock in the Stoxx 600 index is represented by a square tile positioned with X-Y coordinates from top left corner per the first 2 indicators, while a color gradient reflects the third indicator’s value.
  • Rounded tiles indicate each sector’s median, located and colored in the same way as if it were a real stock.
  • Percentage change in target price over the last 6 months is distributed in quartile from left (most negative) to right (most positive), whereby each column represents 25% of all stocks. Hence stocks that are in the bottom quartile (i.e. with negative or minimal positive change in target price over the last 6 months) stand in the 1st column left while stocks in top quartile are in the 4th column to the right.
  • Change in percentage of buy recommendation over the last 3 months works the same way but is distributed in rows rather than columns, from bottom quartile (in 1st row) to top quartile (in 4th row) at the bottom of the screen.
  • Current percentage of buy recommendations is indicated through color gradient, with minimal values in red and maximal values in green.

Telecoms down, minerals up

Above is the whole screen on which we have highlighted telecom stocks with white borders, mainly located in top left corner. In median terms, indicators for telecom stocks reflect:

  • +2.4% change in target price over the last 6 months
  • -1.7% change in buy recommendation over the last 3 months
  • +44% current buy recommendation

Here below is the same screen, but now the highlighted stocks with white borders are mineral resources stocks, located primarily in the bottom right part of the chart. In median terms, mineral resources stocks reflect:

  • +15% change in target price over the last 6 months
  • +1.6% change in buy recommendation over the last 3 months
  • 45% current buy recommendation
Stoxx 600 Sentiment Analysis at 14 July 2017 – Mineral resources stocks highlighted with white borders

Although both sectors currently exhibit similar level of % buy recommendations (approx. 45%), telecom stocks suffer from a persisting downward trend in terms of analysts revisions whereas mineral resources stocks have benefited from significant upward revisions in recent months.

Auto stocks on the watch list

Zooming into the bottom right corner of the chart, we get a closer look at stocks in the upper median group for the first 2 indicators (note that the value shown in each tile is the first indicator, i.e. the % change in target price over the last 6 months).

Stoxx 600 Sentiment Analysis at 14 July 2017 – Bottom-right zoom 

If we move a step forward and filter out stocks that are below the 50% threshold of buy recommendations and then highlight (with white borders) stocks in the Auto and Auto Parts segment, we get the following picture:

Stoxx 600 Sentiment Analysis at 14 July 2017 – Top 50% buy – Auto stocks highlighted with white borders

This analysis emphasizes the current positive market sentiment attached to certain auto stocks (like Ferrari, Volkswagen or Peugeot).

Back-testing the sentimental strategy: the acid-test is passed

Now before we conclude, let’s check out with Sismo’s back-testing tools the historical performance of such a “market sentiment” strategy in a factor-investing approach, with regular portfolio rebalancing.

Consider a portfolio designed to include all Stoxx 600 constituents that initially, 5 years ago, would have fell in the top 30% for all of the 3 market sentiment criteria simultaneously and would have been since then monthly rebalanced on an equal weight basis (i.e. selling stocks that don’t match criteria any longer each month and buying the new matching ones so that all stocks in portfolio would have the same weight in the market capitalization of the portfolio after each monthly rebalancing).

Without discounting for brokerage fees, such portfolio would have led to 16% annual outperformance to the Stoxx 600 over the last 5 years (i.e. +247% total 5Y return vs. +78% for the Stoxx 600). Such portfolio included on average 23 stocks, with a high turnover of nearly 50% of stocks each month.

Stoxx 600 Sentiment Analysis at 14 July 2017 – 5Y-back-test – Monthly equal weight rebalancing

In the previous 5 years (July 2007-July 2012), the top three deciles strategy still beats the Stoxx 600 by 7% annually on average, with a 5-year total return of 9.7% vs -22% for the Stoxx 600.

The analysis should be further developed – and the results adjusted for brokerage fees – but it looks like being “sentimental” is not an attitude that should be ruled out, market-wise…