The Difficult Standard of Predictive Accuracy
On Friday, Britain voted to leave the European Union. Who predicted the outcome? The polls were wrong. The betting markets were wrong. The expert political commentators were wrong.
And this should come as no surprise. Perhaps the most important insight from the social sciences of the last 50 years is the paucity of expert forecasting ability. As Philip Tetlock has amply proven, experts are no better than dart-throwing chimpanzees at predicting political and economic outcomes.
This is worth keeping in mind as the same experts who confidently told us that Britain would never vote to leave the E.U. (unchastened by their obvious failure of predictive accuracy) warn us of the plagues and pestilences that will result from Britain’s decision to reject Brussels’ regulatory super-state.
Predictive accuracy is a difficult standard, but not, however, an impossible one. Social science research reveals that there are ways to make better predictions: rely on historical base rates, use simple algorithmic models, keep track of successes and failures. These methodologies are the foundations of the Verdad approach to markets, and we wanted to highlight a recent prediction we made that was accurate.
On December 15, in one of the first Verdad Weekly Research notes, we observed that high-yield spreads, then at 7.33%, were at five-year highs, making this an excellent buying opportunity for investors willing to take the risk during a time of market turbulence. We argued that buying leveraged equities — the stock of companies issuing high-yield bonds — offered a way to express this bet with greater upside potential, given that equities have unlimited upside and bond values are capped.
“As you can see, and as you’d expect, the equities of these high-yield issuers traded down about 2x as much as their bonds on average. This is exactly how we’d expect leveraged equities to perform,” we wrote. “History tells us that this relationship will hold in the converse and, when spreads tighten, leveraged equities will outperform.”
Investment analysis is useful only insofar as it meets the very difficult standard of predictive accuracy. So we wanted to revisit this prediction and ask: was this forecast correct?
The high-yield spread continued to rise from when I wrote the December 15 note, peaking at 8.87% on February 11. Since then, spreads have dropped to around 6%. The table below compares the performance of bonds and equities for 20 of the largest holdings of the junk-bond ETF, JNK, that also have public stock outstanding from February 11 to June 20.
Figure 1: Equity vs. High-Yield Bond Prices
Source: CapitalIQ
As you can see, the prediction was accurate: when the price of the high-yield bonds rebounded, the equities rebounded significantly more.
Why is this analysis important now? Because junk bonds are still very cheap relative to history, meaning that if you expect these healthy credit conditions to persist, there is significant upside ahead in betting on leveraged equities. Junk bonds yield over 7% right now, so this means leveraged equities should have an expected return of at least 14%.
Last week, the Wall Street Journal wrote, “Some investors are turning again to junk bonds, saying their higher yields make them a good bet at a time when many stocks and government bonds appear richly valued .. Riskier corporate debt, which investors fled in the first month of the year, now pays above-market yields while appearing less stretched than many other asset classes.” We agree: High-yield is historically cheap and leveraged equities are even cheaper — and thus represent an extremely attractive opportunity at a time when most major markets are overpriced.
But you don’t have to just buy the index. Fundamental analysis and quantitative rules can help differentiate between the truly junk companies and the more attractive ones — something we have proved amply this year with Verdad’s fund up almost 35% over the same period as that shown above.
We don’t know what the next few months in the markets will hold. High-yield spreads could rise or fall, economic chaos might or might not ensue, the expert predictions about Brexit’s impact might or might not prove correct. But we are confident that the simple observation made here is correct: the expected return of the equity of companies that issue high-yield bonds is at least double the expected return of the high-yield bonds.
We will continue to hold ourselves to the difficult standard of predictive accuracy, and we hope that we will earn your trust by continuing to make falsifiable predictions, have those predictions come true, and make above-market returns by betting on our analysis being superior in predictive accuracy to that of other market participants