A Deceptively Simple Timing System

Monday, June 19, 2006 | 06:54 AM

Interesting column by Mark Hulbert in the Sunday NYT about an econometric model I have observed over the years and have been impressed with.

What makes it so interesting is the deceptively simple system for assessing risk versus reward in the market place. It does so by tracking just three items:  Stock market Dividend Yield, interest on the 90-day T bill, and the median 3 Year Value Line analyst earnings projection.

Taken together, they forecast trouble for the next 6 quarters:

"The model arose from research conducted some 15 years ago by William Reichenstein, a professor of investments at Baylor University, and Steven P. Rich, a finance professor there. They reported their results in an article in the summer 1993 issue of The Journal of Portfolio Management.

The model is quite simple, especially when compared with many econometric models. It has just three ingredients: the stock market's dividend yield, the interest rate on 90-day Treasury bills and the median of projections from analysts at Value Line, the investment research firm, of how much the 1,700 stocks they monitor will appreciate over the next three to five years. The first two numbers are readily available at many financial Web sites, and the third is published weekly in the Value Line Investment Survey. The formula for combining the three pieces of data can be easily figured with a spreadsheet program or a calculator.

Despite the model's simplicity, the professors found in back testing over the period from 1968 through 1989 that its periodic readings had done an impressive job of forecasting the stock market's gains and losses over the subsequent six calendar quarters."

What makes this so fascinating is that the three elements are unbiased and uncorrupted: the market's dividend yield is real money paid by companies to shareholders, so it cannot be phonied up (even the dividend tax cut only had a minor impact on it); the 90 day T bill interest is also a market determined element. While it is impacted short term by the Fed, it is ultimately set by the bond market; Lastly, the median of projections from analysts at Value Line are free from Investment Banking and/.or Marketing pressures (and other stupidity). Value line has an outstanding track record, and they are completely unbiased and objective, untainted by sellside conflicts.

Here's a chart of the timing model's forecasting history:

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click for larger graph
18strategiesgraphic

graphic courtesy of NYT

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The model forecasts that "the market is likely to underperform garden-variety money market funds through the end of next year." That gloomy forecast is quite consistent with out expectations.

Hulbert notes that the market-timing model "while not perfect, has had an impressive track record over the long run." He writes:

"To be sure, the model has had a mixed record in the 13 years since their study appeared. Though the model has performed well in the current decade, its record in the 1990's was poor. Through much of that decade, it projected below-average performance for the stock market, thereby greatly underestimating equities' actual returns.

The model's failure in the 1990's, however, may be the exception that proves the rule. In an interview, Professor Reichenstein contended that the stock market's outsized returns in that decade were in large part attributable to investor "irrationality," and that the model should therefore not be faulted for failing to forecast them. The model aims to forecast what the market's level would be if investors were rational, and "no model built on rational pricing is able to explain irrational behavior," he said.

A study by The Hulbert Financial Digest provides further support for the notion that the model's failure during the 1990's was an anomaly. The study focused on its performance from 1968 through 2006 — a period that includes the 22 years covered in the professors' original study and the 17 years since. Even after the incorrect forecasts in the 1990's are taken into account, the model's overall record is good enough to be statistically meaningful and not likely to be mere luck."


My only issue is that the time period involved is kinda short and limited -- it covers most of one bear market (1970-82) and all of the next bull market (1982-2000). Valueline started in 1931, so it would be interesting to see how this system did during the prior post WWII Bull market -- especially given the model's miss during the late 1990s moonshot. 

That might provide some insight into whether the system misses these types of strong markets. Or, it might just suggest that the 1995-2000 period was extremely aberational. Either way, it could provide insight into that one predictive failure.

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Source:
An Old Formula That Points to New Worry
MARK HULBERT, Strategies
NYTimes, June 18, 2006
http://www.nytimes.com/2006/06/18/business/yourmoney/18stra.html

Monday, June 19, 2006 | 06:54 AM | Permalink | Comments (18) | TrackBack (1)
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Listed below are links to weblogs that reference A Deceptively Simple Timing System :

» A blink at the stock market from Aloys Hosman
The Blog The Big Picture picked up on a fascinating research published in the NY times. It describes a very simple econometric model from Professor William Reichenstein, that predicts the stock market 6 month ahead. Thats stuf that... [Read More]

Tracked on Jun 21, 2006 1:05:10 PM

Comments

It's easy to see why the model "missed" the bull market of the 90's if it doesn't include any element of human behavior. When belief systems converge in a durable way the market can move in a direction not expected by quantitiative models like this.

The problem as illustrated by dramatic failures like LTCM is that these models work really well, until they don't. Often the change is that beliefs of market players shift and hence break the math.

Posted by: Kris Tuttle | Jun 19, 2006 8:05:55 AM

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