It Takes Two to Tango: Fundamental Timing in Stock Market, a paper co-authored by our school’s Professor Jiang Fuwei (corresponding author), Assistant Professor Tang Guohao (first author) from the College of Finance and Statistics of Hunan University, Dr. Qi Xinlin of Industrial and Commercial Bank of China, and Huang Nan, an investment manager with Harvest Fund, has been accepted for publication by International Journal of Finance & Economics, a world-renowned journal on finance.
The paper puts forward an investment portfolio strategy based on fundamental timing for both Chinese and U.S. stock markets, and finds that information about fundamentals based on stock value and earnings combined with the timing information on short-term momentums based on investment portfolio prices can generate more prominent investment returns than purely buying and holding the stocks of high-value and high-profit companies. In China’s stock market, by backtesting historical data, the investment portfolio strategy of fundamental timing based on value and earnings (compared with the 20-day average price of a specific portfolio) can yield an annualized investment return of around 37%, with an annualized Sharpe ratio of 1.30. After different asset pricing factor models, holding periods and average price signals, as well as transaction costs are taken into consideration, the fundamental timing strategy proposed in the paper can still generate remarkable excess returns. In addition, it finds that the premium effect brought by fundamental timing cannot be simply explained by market timing and economic cycles; but such effect will be amplified in stocks with high idiosyncratic volatility and high illiquidity.
Specifically speaking, the paper employs four indicators to measure a company’s value and profitability (book-to-market ratio, PE ratio, gross profit margin and return on assets), builds fundamental investment portfolios (stock selection) based on annual reports, calculates average price signals of relevant portfolios, and makes timed decisions about whether to hold or sell portfolios by comparing their current prices and average prices. It is found that when the 20-day average price signal is adopted for timing, the four types of investment portfolios based on fundamental timing can all generate notable returns and excess returns, with annualized returns ranging between 34.33% and 41.07%. In the U.S. stock market, the investment portfolio based on the 10-day average price signal yields the highest, with the annualized returns of investment portfolios built on the four indicators ranging between 16.53% and 28.57%. Certainly, the longer timespan of average price signals, the lower returns of investment portfolios. But as the holding period of an investment portfolio increases, the related transaction cost will fall.
In recent years, with the discovery of large numbers of asset pricing factors and the rise of machine learning methods, seeking public and valid information for asset pricing out of different pricing factors has become a popular research subject. The paper’s findings combine stocks’ fundamental information with technical information in a non-linear manner so as to generate notable excess returns, and preliminarily provides a valid economic explanation based on the misvaluation hypothesis of behavioral finance. This not only offers a new perspective for information extraction and combination of different pricing factors, but also useful references for more scientific investment in both Chinese and U.S. stock markets.