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Market timing strategies that worked

  • Pu Shen
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    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.

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    File URL: http://www.kansascityfed.org/Publicat/Reswkpap/pdf/rwp02-01.pdf
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    Paper provided by Federal Reserve Bank of Kansas City in its series Research Working Paper with number RWP 02-01.

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    Date of creation: 2002
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    Handle: RePEc:fip:fedkrw:rwp02-01
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    1. Fama, Eugene F & French, Kenneth R, 1992. " The Cross-Section of Expected Stock Returns," Journal of Finance, American Finance Association, vol. 47(2), pages 427-65, June.
    2. Stephen J. Brown & William N. Goetzmann & Alok Kumar, 1998. "The Dow Theory: William Peter Hamilton's Track Record Reconsidered," Journal of Finance, American Finance Association, vol. 53(4), pages 1311-1333, 08.
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    4. Allan Timmermann & Halbert White & Ryan Sullivan, 1998. "Data-Snooping, Technical Trading, Rule Performance and the Bootstrap," FMG Discussion Papers dp303, Financial Markets Group.
    5. Sydney Ludvigson & Martin Lettau, 1999. "Consumption, aggregate wealth and expected stock returns," Staff Reports 77, Federal Reserve Bank of New York.
    6. Joel Lander & Athanasios Orphanides & Martha Douvogiannis, 1997. "Earnings forecasts and the predictability of stock returns: evidence from trading the S&P," Finance and Economics Discussion Series 1997-6, Board of Governors of the Federal Reserve System (U.S.).
    7. Fama, Eugene F. & French, Kenneth R., 1988. "Dividend yields and expected stock returns," Journal of Financial Economics, Elsevier, vol. 22(1), pages 3-25, October.
    8. Robert J. Shiller, 1984. "Stock Prices and Social Dynamics," Cowles Foundation Discussion Papers 719R, Cowles Foundation for Research in Economics, Yale University.
    9. Cumby, Robert E. & Modest, David M., 1987. "Testing for market timing ability : A framework for forecast evaluation," Journal of Financial Economics, Elsevier, vol. 19(1), pages 169-189, September.
    10. Robert J. Shiller, 1984. "Stock Prices and Social Dynamics," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 15(2), pages 457-510.
    11. Basu, Sanjoy, 1983. "The relationship between earnings' yield, market value and return for NYSE common stocks : Further evidence," Journal of Financial Economics, Elsevier, vol. 12(1), pages 129-156, June.
    12. Owen Lamont, . "Earnings and Expected Returns," CRSP working papers 345, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
    13. Chan, Louis K C & Hamao, Yasushi & Lakonishok, Josef, 1991. " Fundamentals and Stock Returns in Japan," Journal of Finance, American Finance Association, vol. 46(5), pages 1739-64, December.
    14. Jaffe, Jeffrey & Keim, Donald B & Westerfield, Randolph, 1989. " Earnings Yields, Market Values, and Stock Returns," Journal of Finance, American Finance Association, vol. 44(1), pages 135-48, March.
    15. Henriksson, Roy D & Merton, Robert C, 1981. "On Market Timing and Investment Performance. II. Statistical Procedures for Evaluating Forecasting Skills," The Journal of Business, University of Chicago Press, vol. 54(4), pages 513-33, October.
    16. Merton, Robert C, 1981. "On Market Timing and Investment Performance. I. An Equilibrium Theory of Value for Market Forecasts," The Journal of Business, University of Chicago Press, vol. 54(3), pages 363-406, July.
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