Market Timing Strategies

Chart 1: PE Ratio with earnings calculated as 10 year historical average.

In this article, we will take a quick look at the potential to use a more dynamic asset allocation strategy which will shift money out of asset classes which appear overvalued and move money into undervalued classes. This is a classic market timing approach. It is based on the belief that we can determine when the market will probably rise or fall in the intermediate term. If we're correct, we should be able to profit handsomely versus a strategy focused on holding and rebalancing periodically.

Evaluating market timing-based strategies is a big question. Most of the research has indicated that it is very unlikely that an investment manager can successfully time the market (see Charles Ellis 1985). However, given the market's recent collapse and our interest in the predictive power of the long term PE ratio, we'll explore a couple of strategies that seem very reasonable to us.

Hints of Evidence

Before we dive into some analysis of some proposed strategies, let's discuss a couple pieces of data that offer hints that successful market timing might be possible. First, let's take a look at the expected future returns of the S&P 500 when we condition on the value of the long term PE ratio. Table 2 shows the actual average 1 month, 1 year, 5 year, 10 year and 20 year returns for almost 70 years of data when we bucket the starting point into deciles based on the initial long term PE ratio. You'll note that the future returns are well ordered based on decile - so, the periods with the lowest initial PE ratios end up having the highest future returns. This piece of data seems promising. If we know the initial long term PE ratio (which we do), then we should have a pretty good sense of what type of medium and long term returns to expect. Thus, if the medium term returns don't look great, maybe we should shift some money away from this asset class. While this table of data seems fairly logical, it could have profound implications on our ability to time the market.

Table 2: Average annual returns of the S&P index based on initial PE ratio. (Note: The one month return is not annualized)

If domestic equity returns in the future don't look promising, then one place to shift your allocation would be into treasuries. The next logical question would be whether we might be able to predict medium term treasury returns in a similar fashion as we did for the equities. Since we don't have long term PE ratios for treasuries, we could instead use the current rate of return to bucket them into deciles. Take a look at Table 3. Here we see some logical results - treasuries with the largest current return will have the largest expected medium and long term returns. Thus, again, it seems like we can have a pretty good understanding about our future returns by simply knowing some readily available current information.

Table 3: Average annual returns of the T-bills based on initial yield. (Note: one month return is monthly)

While both these pieces of information seem to indicate that there may be a way to construct a market timing-based asset allocation strategy that would significantly outperform a more passive maintain and rebalance strategy. In the next section, we will examine some intuitive, reasonable strategies and see how they fare in practice.

Results of Market Timing Trading Strategies

Now, we will focus on an interesting market timing strategy that relies on the above information to give logical advice to the investor about when to move into or out of the domestic equity market.

Standard Yield Differential

The Standard Yield Differential is an interesting statistic upon which one can create a strategy for dynamically determining portfolio allocations based on an intuitive combination of long term PE ratio values and treasury yields. This model was first discussed in the academic literature by Wong et al. (2001). They define the standard yield differential (SYD) as the value of the long term EP ratio (the reciprocal of the PE ratio) minus the current treasury yield. Let's consider what various levels of the SYD might indicate. If the SYD is high, this implies that the PE ratio is low (thus the EP is high) and the treasury yield is low. Thus, it logically seems like a good indicator to move into equities. On the other hand, if the SYD is low, this means that the PE ratio is high (EP is low) and the treasury is high. This would indicate a good time to remain in treasuries.

SYD = 1/PE – T_yield

We like this simple model for several reasons:

• The long term PE ratios appear to have good medium term predictive power for equity returns

• The current treasury yield appears to have good predictive power for the medium term treasury returns

• The SYD is a very intuitive and logical allocation strategy

• The SYD can be very easily calculated and, therefore, an allocation based on this figure would be relatively easy to implement

It appears like this might be the type of quantitative model that could produce a market timing-based dynamic asset allocation model that would outperform a fixed allocation strategy. Next, we'll look at how one implementation performs against historical data.

Academic Studies

In 2002, Shen released a study using the SYD to determine when a portfolio should be invested in equities and when its allocation should be moved to treasuries. His method was to move his portfolio from equities to treasuries whenever the value of the SYD was below its historical 10th percentile value. This decision rule ensures that the investor will be invested in equities for the vast majority of time periods. The allocation decision was made on a monthly basis. In other words, he is trying to keep money in equities except when a very low historical value of the SYD occurs. In his analysis, he calculated two different versions of the SYD - one based on the yield of a 3 month treasury bill (the short model) and one based on the yield of the 10 year treasury bond (the long model). He looked at 30 years of data from 1970 to 2000. See his results in Table 4. As you can observe, his strategy based on the SYD short model achieved an average monthly return of 1.5% while remaining invested in equities for 78%. This average return significantly beat the return of remaining invested in equities for the entire time period. Additionally, it produces a better Sharpe ratio. Thus, Shen's results suggest that an asset allocation strategy based on the SYD can produce significantly better returns than merely remaining invested in equities through thick and thin.

Table 4: Returns of SYD strategies reported by Shen (2002).

In 2005, Brooks et al. wrote a paper where they examined the potential of several strategies which attempt to time the market. They included the two Shen SYD models in their analysis. They used a much longer time horizon to evaluate their models (from 1927 to 2003) than Shen. Their results can be found in Table 5. You can see that the SYD short model again outperforms the fully equity invested results but the difference is very small. The SYD long model actually underperforms the strategy of remaining in equities during all time periods. This casts doubt on the value of using an SYD-based strategy. It does improve returns and Sharpe ratio slightly but you must choose the correct version of the SYD model. An obvious question to ask would be: why do the results of the SYD model differ significantly when the time period is extended? We believe that the problem lies in Shen's analysis as we will explore in the next section.

Table 5: Returns of SYD strategies reported by Brooks et al. (2005).

Sigma’s Results

Since these two academic papers produced such different results, we thought it prudent to conduct our own analysis to validate their results. Using our own equities and bond data from Shiller, we implemented the various models and our results can be found in Table 6. The first point to note is that our results for the SYD short model with Shen’s time periods were much different than what he reported. In fact, they are almost equivalent in average return to a strategy of remaining in equities at all periods (although the SYD short does produce a better Sharpe ratio). Our figures matched the Brooks et al. analysis very closely. After checking and re-checking, we are convinced that Shen made an error in his analysis. Thus, it appears that implementing allocation strategies based on the SYD won't produce better overall returns but they might reduce volatility and increase the Sharpe ratio.

Table 6: Sigma’s calculated returns of SYD strategies.

Explaining the Performance of the SYD Short Strategy

Now, we will examine why these returns for the SYD-based approaches don't live up their promise as a means of identifying future periods of high or low equity returns and allocating your portfolio accordingly. First, let's examine when Shen's SYD short model indicated that the investor should have moved his funds into treasuries. In Chart 7, the green boxes represent periods when the portfolio would have been invested in treasuries.