Seeking Alpha

Simplified Equity Risk Premium: A Market Timing Indicator Tested Since 1876

|
Includes: IVV, SPY, VOO
by: Fred Piard
Summary

Absolute valuation is a bad market timing indicator.

Relative valuation seems to work better.

Here is an example of indicator.

The simplified equity risk premium (hereafter SEP) aims at measuring the difference between the expected annual return of a stock index and a safe bond yield. SEP is inspired by what is known as the Fed model.

It is defined as:

SEP = (E/P) - GS10

Where:

  • E is the aggregate estimate earnings of the US large cap stock index S&P 500. It is a monthly data series calculated as a linear approximation using the latest published earnings and estimates of future earnings for the S&P 500. For vintage data, we use Robert Shiller's online data. For current updates, we prefer using data published by S&P Dow Jones Indices. Some implementations of the Fed model look forward by using projected future EPS (for example for the current or next year). Our "E" is more short-sighted and reflects the current state of the economy.
  • P is the monthly price of S&P 500, defined as the average of daily closing prices.
  • GS10 is the 10-Year Treasury Constant Maturity Rate (GS10 is the name of the data series in Saint Louis Fed's database)

On the 1st day of month "m", we can make decisions using SEP(m-1), calculated from the data of the month ending the day before.

SEP(m-1) = (E(m-1) / SPX(m-1)) - GS10(m-1)

I will show market timing test results based on monthly decisions. Indicators are observed on the 1st day of every month. Each indicator gives a binary signal "bullish" (0) or "bearish" (1). Every indicator is tested by calculating the performance of an investment in the S&P 500 (VOO, or IVV, SPY) with a market timing strategy going gradually out of the market during the month of a bearish signal. Gradualness is simulated using the average of daily closing prices as monthly price. It means a trade "off" or "on" is smoothed along the month, as if 1/21 of the trade was executed every day on market closing for an average month of 21 trading days. The first advantage is that it is easy to get a free and reliable price data series based on this rationale on a very long period (Robert Shiller's online data). The second advantage of using smoothed monthly prices is a lower sensitivity to short-term moves. There is no risk to design a model unwillingly curve-fitted to a series of specific daily prices (the first trading days of every month). There is a third advantage: it is more realistic for investors who cannot make a big move on a single day because of capital size or compliance (especially fund managers).

The following tests simulate going to cash on a bearish signal. Obviously, this is rarely the best strategy. Opening or increasing hedging positions is usually a better way to manage riskier periods, incurring lower trading costs when the portfolio is in many positions or when holdings are not very liquid. It also keeps dividends coming when there are some.

After trying several possible indicators, two seemed to work quite well, and even better together. The next table and chart show results about this combination. My indicator is bearish when the 3-month simple moving average of SEP (3mma) is below both the 2-year average (24mma) and the 5-year average (60mma), and bullish otherwise.

Earnings estimates, therefore SEP, are subject to revisions. The amplitude and impact of these revisions are difficult to evaluate. I generally use data delayed by 1 month to perform robustness tests on revised data. For SEP, I want a larger safety net and use data delayed by 2 months. It is a way to check the model is not too time-sensitive and also how estimate EPS revisions may affect the result.

In the tables below:

  • CAGR is the annualized return in percentage points.
  • Ddmax is the maximum drawdown depth also in percentage.
  • DLmax is the maximum duration in months.
  • MAR ratio is a risk-adjusted performance metric defined as MAR = CAGR/Ddmax.
  • The first column gives the starting year for each test, the end date is always 1/1/2019.
  • For all tables, benchmark data are repeated in italic to facilitate comparisons (S&P 500, buy and hold).

In the first series of tests below, the bearish signal is given by 3mma < 24mma and 3mma < 60mma.

Since

CAGR

MAR

Ddmax

DLmax

CAGR

MAR

Ddmax

DLmax

2000

3.22

0.06

50.82

80

5.35

0.35

15.22

31

1956

6.68

0.13

50.82

89

6.73

0.17

38.92

74

1913

5.45

0.06

84.76

299

5.88

0.11

53.40

345

1876

4.55

0.05

84.76

299

4.74

0.09

53.40

345

The second series is the robustness test for the same condition with data delayed by 2 months, considering the latest available value is SEP(m-3).

Since

CAGR

MAR

Ddmax

DLmax

CAGR

MAR

Ddmax

DLmax

2000

3.22

0.06

50.82

80

3.76

0.15

25.70

58

1956

6.68

0.13

50.82

89

6.49

0.17

38.92

75

1913

5.45

0.06

84.76

299

4.90

0.08

60.57

292

1876

4.55

0.05

84.76

299

4.17

0.07

60.57

292

Chart since 1993:

Our SEP indicator improves the drawdown and MAR ratio on all studied intervals. The robustness test with delayed data shows a degradation but still improves Ddmax and MAR on all intervals. However, the tests reported here could not have been executed as investing strategies at every point in the past due to data revisions.

SEP was bullish in my latest update for subscribers.

Disclosure: I am/we are long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.