The purpose of this study is to examine the pertinence of combining the positioning along the US presidential election cycle and the inversions of the yield curve as a guide for a market timing strategy on the S&P 500. These variables provide warning signals for either an abnormally high probability of tighter future economic conditions or an abnormally high probability of more accommodative future economic conditions, not both. As such, they represent natural complement.
The combination of the two variables leads to four scenarios: inverted yield curve or not and first half or second half of the presidential cycle. Two timing strategies are proposed to act on these scenarios: the “type T” strategy for Traditional investors not allowed to sell short and focusing on active risk focus and the “type H” strategy for Hedge Fund‐like investors focusing on absolute risk.
Compared to a buy‐and‐hold investment in the S&P 500, the “type H” version increases the return per unit of risk from 0.81 to 1.10 and the “type T” delivers an annualized information ratio of 0.62. Robustness tests show that the strategy adds value under both specifications in the majority of 1‐, 3‐ and 10‐year sub‐periods. Application of the Henriksson‐Merton test confirms that the two strategies have a genuine market timing ability.
While the predictive variables have been investigated on a standalone basis, the idea of combining these two predictors is new. The idea of examining market timing from the perspective of both traditional investor and hedge fund like investor is also original.
