Sep

1

Any thoughts on the paper "The Two-Year Effect" by Graham Bornholt ?

This paper identifies a puzzling form of predictability in U.S. stock market portfolios. For the value weighted market index, those years that follow a low return two years earlier have an average return 11.6% higher than those years that follow a high return two years earlier. The difference in returns is economically and statistically significant.

Vic and Laurel reply:

Let us say it does not come as a complete surprise; the strong negative correlation between the current year return and the return two years back is mentioned in our book Practical Speculation on pages 210-211. See in particular Table 9.2 on Page 211,
9.2

We invite the submission of relevant analyses.

Kim Zussman follows up:

Using SP500 (w/o dividends) I checked Dec-Dec returns 1950-07 for years coming 2 years after down years (the year after the year after a down year). Comparing these with all yearly returns for the series showed them to be higher, but the difference is not statistically significant:

Phil McDonnell expresses skepticism:

One way to test for a two year negative correlation is to calculate a correlation coefficient with a lag of 24 months. For S&P adjusted [monthly] returns from 1950 to 2005 we get the following correlations at the various monthly lags from 18 months to 33 months:

Dr Phil autocorr table

Note that the correlation at 24 months is actually +1.55% which does not support the idea of a negative correlation at two years. However overall most of the monthly correlations are negative in the 18 month to 33 month range. Another indication of how weak any effect may be is that none of the correlations rise to the level of 5% significance. Given that there are 16 chances we might expect that at least one would be significant by chance alone.

Dr. McDonnell is the author of Optimal Portfolio Modeling, Wiley, 2008

Alex Castaldo replies:

I thought we were discussing yearly returns, not monthly. You lost me somewhere.


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