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Based on the E/P ratio of the S&P 500 and interest rates.
Few investment strategies have a worse reputation than market timing. Investors are told that their best strategy in stock investing is a simple buy-- and-hold strategy: Buy a diversified stock market index, and hold it. Yet most investment literature assumes that investors will hold a security if and only if its expected return at the market price provides an adequate trade-off with the additional risk exposure the security brings. In other words, investors are assumed to make their own judgment on whether a security is worth holding.
Saying that investors should not time the market is equivalent to saying that consumers should not maximize utility when they make consumption decisions. The standard reply to this criticism is that because the stock market is fairly efficient, accurate market timing is very difficult. In fact, it is said to be so difficult that investors are better off not trying.1
We describe a few simple market timing strategies that would have worked well over the past three decades, using real-time data. The simplicity and the effectiveness of these strategies challenge the notion that market timing is inherently difficult.
The particular focus is strategies related to spreads between the E/P ratio of the S&P 500 index and interest rates. As most media attention to these spreads occurs when they are extremely high (such as in the 1970s) or extremely low (such as in 1999 and 2000), we consider whether extreme values of the spreads provide useful information for timing the market.
These strategies are better characterized as modified buy-and-hold rather than as active market timing strategies. They are based on the belief that on average stock prices generally reflect fundamentals, but at rare times even aggregate market prices diverge widely from fundamentals. Further, such rare times may be hinted at by extreme values of the spreads.
For example, when the market is dominated by overly optimistic sentiment, the E/P ratio of the market index is more likely to be extremely low compared to yields of alternative investments, such as debt instruments. Therefore, extremely low values of spreads may indicate that most stock prices are too high to be justified by fundamentals, and it may be a...