Market Timing in Nordic Countries Using the Yield Spread

Abstract

The economists and academics have stated for the last 30 years that the yield spread, a difference between long- and short-term interest rates, is a reliable predictor for the future economic activity. A negative yield spread has been an extremely reliable recession indicator in the U.S. during the past 70 years since the value of the yield spread has turned negative before every latest seven recessions. Several studies suggest, that the relationship between the value of the yield spread and economic activity exists also in other developed countries. Moreover, some evidence suggests that the yield spread can be used as a predicting tool for the future stock market movements.

This thesis examines the relationship between the long- and short-term government bond yield spread and the bear stock markets in four Nordic countries, Finland, Sweden, Norway, and Denmark between 1990 and 2018. At first, the bear market probabilities one month in advance are calculated by using the probit model. Three different probit models are used to examine how different variables impact on the bear market probability estimations. Next, the market timing simulations will be tested with nine probability screens. If the bear market probability estimation exceeds the probability screen, the portfolio will be switched from stocks to the risk-free rate, and vice versa.

The probit model estimations suggest that the home country yield spread is an accurate predicting tool for future stock market movement. When the value of the yield spread narrows, the bear stock market probability increases. When other variables, the U.S. yield spread and the inflation rates, are included in the model, the results indicate that that the home country yield spread is driving the estimation results for each model. The market timing estimations suggest that the market timing strategy outperforms traditional buy-and-hold strategy in most of the cases. In addition, the market timing returns tend to be remarkably higher when the inflation rates are included in the model with the home country yield spread.