MyPlanIQ's  Instablog

MyPlanIQ
Send Message
MyPlanIQ.com is the only web application that offers advanced asset allocation strategies customized to a wide range of retirement and taxable investment plans such as 401(k), IRA and brokerage accounts. The unique key advantages of MyPlanIQ.com are 1. Superior investment strategies with high... More
My company:
LTI Systems, Inc.
My blog:
MyPlanIQ News and Articles
  • Market Timing Strategies Based on Financial and Sentiment Indicators 0 comments
    Sep 16, 2009 11:42 AM | about stocks: BWX, CRED, CIU, CSJ, DVY, EFA, EEM, BND, HYG, IWM, JNK, LQD, MDY, SHV, SHY, SPY, TIP, TLT

    Market timing strategies have been controversial: academics published many studies in this subject and most of them concluded that it is useless to pursue market timing. On the other hand, practitioners have been using this for many years (explicitly or implicitly). In a paper published by Neuhier and Schlusche in Feb. 2009, titled as Data Snooping and Market-Timing Rule Performance, the study examined stock market timing strategies based on various combinations of financial and sentiment indicators. The paper's conclusion is mostly negative on those strategies based on historical simulation during the period from 1981 to 2007. With the recent market upheavals, it is interesting to revisit these strategies by including the period since 2007 to now.

    The basic idea behind these strategies is to remain invested in the stock market when expected returns are high and switch to cash investments when the market is expected to under perform. Investors long securities but temporarily exit the market and switch to holding cash in bad times based on certain timing indicators. By avoiding exposure to stock market during the weakest months and being long during the rest of the time, one would hope to reduce risk and achieve a reasonable return. The key to measure the performance of these strategies should include the risk factors such as maximum draw down (measured as the maximum from a peak to a following trough percentage), standard deviation and Sharpe ratio (the so called risk adjusted return).

    ValidFi recently released various stock market timing strategies based on the description from the paper. These strategies and their model portfolios are now lively monitored on validfi.com. These strategies employ the following indicators:

    • Financial indicators
      • Earning to price: essentially this is the S&P 500 PE ratio.
      • Dividend yield: this indicator is tracking S&P 500 companies' aggregate dividend yields in the past 12 months.
      • Dividend payout ratio: S&P 500 dividend payout ratio.
      • Bond to equity: the relative bond yield and earning yield relationship. The so called Fed model is one version of this.

       

    • Interest rate indicators
      • Long term interest rate: based on long term Treasury bond yield. This indicator is sensitive to long term inflation expectation.
      • Short term interest rate: based on short term Treasury bill yield.
      • Maturity spread: the difference between long term and short term bond yields.
      • Credit spread: the difference between high yield (junk) bond and the investment grade corporate bond yield. The bigger the spread, the higher investors' risk appetite is.
      • Expected inflation: difference between nominal and real interest rate.

       

    • Sentiment indicators
      • CBOE equity put/call ratio: the short term total equity put volume over the short term total equity call volume.
      • CBOE S&P 500 implied volatility VIX: the implied volatility of short term option contracts on S&P 500 index. This indicator is also called 'fear factor'.

       

    In these strategies, several threshold values of the indicators are considered. They are either a historical value, such as the moving average or a certain percentile or a fixed number. Other parameters include delay days (number of days waited to take an equity position after a switching signal) and waiting days (minimum number of days to keep a position after switching).  The model portfolios have various parameter settings. In general, we find using SMA30 or SMA120 (30 or 120 days Simple Moving Average) are the most natural ways to set the parameters even though they might not be the best parameters.

    The following table illustrates the performance of these strategies with the best parameter settings. From the table, one could see that financial indicator long term interest rate, interest rate indicator credit spread and the sentiment indicator put/call ratio have the best Sharpe ratios in the period monitored. The long term interest rate, being sensitive to the economic condition, surprisingly has an excellent predictive effect since 1963. On the other hand, the expected inflation based strategy has quite a bit under performance. We believe it might be due to the inaccurate estimate methodology used.

    Table 1: The Best Performance Portfolio of Each Market Timing Strategy

    (From start date to 9/9/2009)

     

    Timing on S&P 500 Index

    Timing

    Timing

    Buy and Hold S&P 500 Index (dividend is not reinvested)

    Buy and Hold

    Buy and Hold

    Indicator

    Parameters

    AR

    Sharpe

    Start Date

    AR

    Sharpe

    Long Term Interest Rate

    SMA30, 5, 5

    9.58%

    0.481

    4/1/1987

    5.78%

    0.148

    Short Term Interest Rate

    SMA30,1,1

    4.82%

    0.081

    1/1/1963

    6.16%

    0.142

    Maturity Spread

    SMA30, 5, 5

    3.37%

    -0.041

    1/1/1963

    6.16%

    0.142

    Earning to Price

    SMA30, 1, 1

    6.27%

    0.271

    1/1/1990

    5.60%

    0.158

    Dividend Yield

    SMA30, 1, 1

    3.26%

    0.053

    1/1/1990

    5.60%

    0.158

    Bond to Equity

    SMA30, 1, 1

    6.54%

    0.253

    1/1/1990

    5.60%

    0.158

    Dividend Payout Ratio

    SMA120, 5, 5

    6.57%

    0.307

    1/1/1990

    5.60%

    0.158

    Credit Spread

    SMA30, 1, 1

    8.53%

    0.404

    1/1/1997

    2.66%

    0.019

    VIX

    SMA30, 5, 5

    4.17%

    0.137

    1/1/1991

    6.29%

    0.201

    Expected Inflation

    SMA30, 1, 1

    1.72%

    0.004

    1/1/2003

    2.44%

    0.035

    Put/Call Ratio

    SMA30, 5, 5

    7.54%

    0.377

    1/1/2004

    -1.28%

    -0.137

    Learning

    256, 256

    5.85%

    0.237

    1/1/1990

    5.60%

    0.158

    Voting

    0.6, 1 month

    4.22%

    0.107

    1/1/1990

    5.60%

    0.158

     

     

    In addition to the live strategies mentioned above, ValidFi also maintains a 360 degree market view page to monitor various indicators and most asset classes trends.

    This article only serves as an introduction to the above strategies. We will have more follow up articles to discuss individual strategies in more detail.

    Disclosure: No Positions

    Stocks: BWX, CRED, CIU, CSJ, DVY, EFA, EEM, BND, HYG, IWM, JNK, LQD, MDY, SHV, SHY, SPY, TIP, TLT
Back To MyPlanIQ's Instablog HomePage »

Instablogs are blogs which are instantly set up and networked within the Seeking Alpha community. Instablog posts are not selected, edited or screened by Seeking Alpha editors, in contrast to contributors' articles.

Comments (0)
Track new comments
Be the first to comment
Full index of posts »
Latest Followers

StockTalks

More »

Latest Comments


Instablogs are Seeking Alpha's free blogging platform customized for finance, with instant set up and exposure to millions of readers interested in the financial markets. Publish your own instablog in minutes.