Market-Timing
Strategies That Worked
By Pu Shen
May 2002
RWP 02-01
Research Division
Federal Reserve Bank of Kansas City
Abstract
In this paper, we present a few simple market-timing strategies that appear to outperform the "buy-and-hold" strategy, with real-time data from 1970 to 2000. Our focus is on spreads between the E/P ratio of the S&P 500 index and interest rates. Extremely low spreads, as compared to their historical ranges, appear to predict higher frequencies of subsequent market downturns in monthly data. We construct "horse races" between switching strategies based on extremely low spreads and the market index. Switching strategies call for investing in the stock market index unless spreads are lower than predefined thresholds. We find that switching strategies outperformed the market index in the sense that they provide higher mean returns and lower variances. In particular, the strategy based on the spread between the E/P ratio and a short-term interest rate comfortably and robustly beat the market index even when transaction costs are incorporated.
Keywords: Investment, stock market, earning yields
JEL Codes: G10, G11, G14
Pu Shen is an economist at the Federal Reserve Bank of Kansas City. Douglas Rolph co-authored an earlier draft of this work entitled "Do the Spreads between the E/P Ratio and Interest Rates Contain Information on Future Equity Market Movements?" (RWP 99-03), which can be found at www.kansascityfed.org/publicat/reswkpap/rwp99.htm. The author is grateful for the excellent research assistance provided by Jonathan Corning, a research associate at the Federal Reserve Bank of Kansas City.The views expressed in this paper are solely those of the author and do not necessarily reflect the views of the Federal Reserve Bank of Kansas City or the Federal Reserve System.
Shen e-mail: pu.shen@kc.frb.org