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Market Timing Strategies Based on Financial and Sentiment Indicators

|Includes:BND, SPDR Barclays International Treasury Bond ETF (BWX), CIU, CRED, CSJ, DVY, EEM, EFA, 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