Market-timing strategies using bond-equity yield ratio

Abstract

The purpose of this paper is twofold. First it aims to investigate whether an augmented valuation ratio BEYR can be used to forecast UK stock market aggregate and industry sector returns, and secondly whether BEYR can be used as an indicator to construct effective market-timing strategy that outperforms buy-and-hold -strategy. To investigate forecasting ability of BEYR, cointegration tests are conducted to see whether there exists a long-run relationship between the BEYR components, stock prices, earnings (dividends) and government bond yield. Two market-timing strategies are constructed using BEYR as an indicator. First strategy (THVS) uses historical BEYR values as thresholds to move in or out of equities and the second strategy (RSS) aims to identify regime switches in the BEYR.

The sample includes monthly observations of FTSE All-Share Index and 10 industry sector indices spanning from 1999 to 2014. The BEYR is constructed using equity and dividend yields (D/P and E/P) and 10-year UK Government Bond Index. The performance of the market-timing strategies is evaluated against buy-and-hold strategies by absolute returns in terms of terminal wealth and risk-adjusted basis by using Sharpe-ratio as criterion.

The results show that BEYR’s ability to forecast UK stock market returns is weak. Contrary to earlier studies, cointegration tests show that there is a long-term relationship between the BEYR components only in five industry sector indices. However, evaluation of the two market-timing strategies show that the BEYR can be used in asset allocation to obtain higher absolute and risk-adjusted returns compared to buy-and-hold strategies. Out of the two strategies, RSS performs significantly better in most sectors whereas the performance of THVS is economically insignificant compared to passive strategy. The results are generally better when BEYR with earnings instead of dividends is used.