Quantitative Stock Rating Model: Performance and Discussion
Our quantitative stock rating model, launched at the beginning of this year, uses composite factors across five dimensions (value, quality, momentum, estimates, and investment) to predict individual stock performance. The stock rating model produces a list of 100 favored investments from across the S&P 500.
The model enjoyed its best month of the year in November, as its basket of favored stocks outperformed the S&P 500 index by 3.0%. Year-to-date, the favored basket has outperformed the S&P 500 by 8.4%. Fig. 1 shows the performance of the basket of favored stocks and the S&P 500 by year, starting in 2001.
Fig. 2 shows the performance for each of the 5 composite factors that make up the stock rating model (blue bars), along with the performance of the overall model (orange bar at right) during November. Of the five composite factors, four outperformed the overall index. The quality composite led the way with relative outperformance of 2.8%, while the value composite also contributed 2.3% of outperformance. The investment composite also outperformed the S&P 500 by 1.3%.
The momentum composite was the only one of the five which underperformed in November. The negative return for momentum in November ended a three-month run of relative outperformance for the composite.
Market Valuation: Residual Income Model
We use a residual income model to value the market. The residual income model produces an estimate for the equity risk premium, or the additional return that equity investors are compensated over the risk-free rate.
Using the equity risk premium, we can evaluate the relative attractiveness of equities compared to investment grade fixed income via the ratio of their yields (see Fig. 3). Historically, when equities are expensive compared to fixed income (i.e., equities have a relatively low yield) the stock market experiences smaller average returns and higher volatility.
The latest reading for the yield ratio indicates that equities remain overvalued relative to investment grade fixed income. As a result, we expect muted returns and higher volatility for the equity market over the next 3 months.
 See Market Valuation Report