Return Predictability, Market Timing and Volatility: Evidence from the Short Rate Revisited

Abstract

We revisit the evidence on the economic value of the predictive ability of the short rate for excess stock returns using market timing regressions and seven decades of US market data on aggregate indices, size decile portfolios and industry portfolios. We ask two questions. First, has the economic value of the predictive power of the short rate for stock returns changed over time? Second, can information on return volatility be used to enhance the profitability of market timing strategies? Our main results are as follows: first, we find that the economic value, to a naive investor, of the predictive ability of the short rate is low prior to the 1951 Treasury Accord period, high during the period 1950-1975 and has disappeared in the last two decades. We also find that the short rate has the most predictive ability for the durables industry sector and the smaller size stock portfolios. Second, we find that that market timing strategies are most profitable during periods of intermediate volatility. Our contribution here is to propose a new and simple approach that allows investors to significantly enhance the profitability of market timing strategies by optimally using information both in return and volatility forecasts.

Key words: Return predictability; short rate, sign regressions, filter rules, volatility

JEL Classification: G12