Avoid Equity Bear Markets with a Market Timing Strategy

Ladislav Ďurian
Quant Analyst, Quantpedia.com

Radovan Vojtko
CEO & Head of Research, Quantpedia.com

Abstract

In this paper, our goal is to construct a market timing strategy that would reliably sidestep the
equity market during bear markets and thereby reduce market volatility and boost risk-adjusted
returns. We build trading signals based on price-based indicators, macroeconomic indicators,
and a leading indicator, a yield curve, that can predict recessions and bear markets in advance.
Our best-performing strategy uses signals from the Treasury spread, a 200-day SMA, and an
alternative risk metric, the Rachev ratio, as trend indicators, while Real Retail Sales Growth,
Industrial Production Growth, and S&P Composite dividends as macroeconomic indicators.
Based on the sample period from 1927 to 2022, it yields an annual excess return of 7.05%, well
above the market return, while doubling the market Sharpe ratio to 0.60 and cutting the maximal
drawdown by two-thirds to -25.13%.

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1 Introduction

Market timing is an act of moving in and out of a financial market based on some predictive
methods. Its main objective is to reduce the risk associated with equity investments. Market
timing does not attempt to beat the market on a performance basis. Given their lower volatility,
market timing strategies aim to outperform the market on a risk-adjusted basis. Although by
implementing leverage, it is also possible to beat the market on a performance basis. The only
way market timing strategies can reduce market volatility is to avoid the large drawdowns that
equities periodically produce. To reliably sidestep market downturns, it is necessary to know
when they are likely to occur. The most straightforward approach would be to get out of the
market whenever a negative trend arises.

The identification of the market trend can be realized through technical analysis, which is a
methodology for analyzing and forecasting the direction of prices. A fundamental principle of
technical analysis is that prices move in trends. Technical analysts believe that these trends can
be identified in a timely manner to generate profits and limit losses. Trend following is an active
trading strategy that implements this idea in practice. The most popular trend-following rules
are the Momentum (MOM) rule and the Moving Average (MA) rule. In the MOM rule, a buy
signal is generated when the current price is above its value n periods ago. In an MA rule, on
the other hand, a buy signal is generated when the current price is higher than a moving average
of prices over the past n periods. The most widely used MA strategy uses Simple MA (SMA),
while others rely on Linear MA (LMA) and Exponential MA (EMA). A recent paper by
Zakamulin and Giner (2018) compares these two most popular trend-following rules and finds
that the MA rule has more robust forecast accuracy of the future direction of price trends
compared to the MOM rule.

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Market timing with moving averages has been the subject of substantial interest from academics
and investors. In his book, Siegel (2008) investigates the use of the 200-day SMA in timing the
Dow Jones Industrial Average (DJIA) from 1886 to 2006. His strategy bought the DJIA when
it closed at least 1 percent above the 200-day moving average and sold the DJIA when it closed
at least 1 percent below the 200-day moving average. He concludes that market timing improves
the absolute and risk-adjusted returns over buying and holding the DJIA. In a similar manner,
Faber (2013) introduces a market timing model called Global Tactical Asset Allocation
(GTAA), consisting of five global asset classes, where he employs a 10-month SMA to evaluate
whether to hold the assets on a monthly basis. In the 1973-2012 period, his model outperformed
the S&P 500 index, achieving equity-like returns with bond-like volatility and drawdowns.

In this paper, we attempt to construct a market timing strategy that would reliably sidestep the
equity market during bear markets and thereby reduce market volatility and boost risk-adjusted
returns. Our investment universe consists of the market factor of Fama and French (MKT) and
the risk-free rate (RF). MKT buys all CRSP firms incorporated in the US and listed on the
NYSE, AMEX, or NASDAQ that have a CRSP share code of 10 or 11. RF is the one-month
Treasury bill rate. At the end of each month, we evaluate whether the market will post a positive
return over the next month, and we switch between the MKT and RF accordingly. Therefore,
when we are not invested in MKT, we hold RF. Since Fama and French report MKT returns in
excess of RF, we also report returns for all our strategies in excess of RF in the remainder of
the paper. We sourced MKT excess returns from Kenneth French’s website for the period from
July 1926 to June 2022, which is our sample period. Note that the first few months of the sample
period are used to construct our strategies, and therefore the period for which we report results
in our tables is slightly shorter than our initial sample period.

To gauge the relative performance of our model, we construct a Naive market timing strategy
which would be our main benchmark for the rest of the paper. Naive buys or stays long the MKT
if the MKT price is above its 200-day moving average. Otherwise, the strategy switches out of
the stock market. Our first step would be to improve the Naive market timing using price-based
indicators.

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2 Market Timing Using Price-based Indicators

One of the signals of an upcoming bear market in a stock is when the 50-day SMA crosses the
200-day SMA to the downside, an event referred to as the death cross. Similarly, the 50-day
SMA crossing over 200-day SMA to the upside is an indication of an impending bull market in
a stock, an event called a golden cross. In this manner, we construct the MA (50, 200) strategy
that buys or stays long the MKT if its 50-day moving average is above the 200-day moving
average. Otherwise, the strategy switches out of the stock market.

Another widely watched sign of an imminent market downturn is a spike in short-term volatility
relative to long-term volatility. Therefore, we construct a trading strategy that buys equities only
if the short-term volatility is below the long-term volatility. Specifically, VOL (50, 200) buys or
stays long the MKT if the 50-day historical volatility, measured by the standard deviation of
market returns is below the 200-day historical volatility. Otherwise, the strategy switches out
of the stock market.

Volatility considers both extremely high and extremely low returns equally undesirable.
Investors, however, want to limit only the downside risk and keep the upside unbounded. To
this end, we decompose the market volatility into upside and downside volatility. In particular,
we compute the upside (downside) volatility as the standard deviation of positive (negative)
market returns over a given period. Thus, our strategy, VOL (200)+,- buys or stays long the MKT
if the upside volatility over the past 200 days is greater than the downside volatility. Otherwise,
the strategy switches out of the stock market.

The broad stock market is considered to have a negatively skewed distribution. The notion is
that the market more often produces a small positive return relative to a large negative loss.
However, during bear markets, the situation reverts and the market posts small losses more
frequently than large gains. Several studies investigate the skewness effect and its implication
for the cross-section of stock returns. Zaremba and Nowak (2015) found that country equity
indices with the most negative historic skewness outperform those with the most positive
skewness. Building upon their findings, we construct our SKEW (200) strategy that buys or
stays long the MKT if the historic skewness measured by the skewness coefficient in the latest
200 days is below zero. Otherwise, the strategy switches out of the stock market.

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Looking at the performance of our strategies so far, Table 1 shows that none of them exhibit
better results than Naive, neither on a performance nor risk-adjusted basis. What’s more, some
of them suffered drawdowns close to that of MKT. These weak results motivated us to dig
deeper and look for more complex price indicators of the market trend, which led us to the
Relative Strength Index.

The Relative Strength Index (RSI) is a momentum indicator used in technical analysis to
measure the velocity and magnitude of price movements. As a momentum indicator, the RSI
compares a security’s strength on days when prices go up to its strength on days when prices
go down. Traders often use RSI to evaluate whether the security is overvalued or undervalued.
Traditionally, RSI readings above the 70 level indicate that the security is overbought, and RSI
readings below 30 imply that the security is oversold. However, RSI can also be used to identify
a change in trend. A movement from below the centerline (50) to above indicates a bullish trend.
A movement from above the centerline (50) to below indicates a bearish trend. Our RSI (200)
strategy is based on the RSI crossovers the centerline as it buys or stays long the MKT when
the 200-day Culter’s RSI is above 50. Cutler’s version of RSI uses SMAs for smoothing instead
of EMAs. Otherwise, the strategy switches out of the stock market.

Another possibility to increase market risk-adjusted returns is to stay in the market only if, in
the recent period market exhibited favorable risk-adjusted returns. We measure market risk-
adjusted return using an alternative performance measure called the Rachev ratio (RR). RR,
devised by Bulgarian mathematician Svetlozar Rachev measures the right-tail reward potential
of a security relative to the left-tail risk. Stoyanov, Rachev, and Fabozzi (2005) defined the RR
as a ratio of two Conditional Value at Risk (CVaR) values as follows:

𝐶𝑉𝑎𝑅1−𝛼 (𝑟𝑓 − 𝑟)
𝑅𝑅(1−𝛼,1−𝛽) =
𝐶𝑉𝑎𝑅1−𝛽 (𝑟 − 𝑟𝑓 )

where 𝑟 is a return on a portfolio or asset, 𝑟𝑓 is the risk-free rate and 𝛼, 𝛽 ∈ (0,1). Simply put,
RR measures the ratio of 𝛼% best returns to 𝛽% worst returns. In our case, 𝛼 = 𝛽 = 0.5, and we
compute the ratio using the latest 200 days. Our RR (0.5, 0.5) strategy buys MKT when the RR
is greater than one. Otherwise, the strategy switches out of the stock market.

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Table 1 displays that our two new strategies RSI (200) and RR (0.5, 0.5) did significantly better
compared to our former strategies MA (50, 200), VOL (50, 200), VOL (200)+,- and SKEW (200).
RSI (200) exhibits an annual excess return of 6.40%, which is greater than the 6.30% p.a.
achieved by the Naive strategy. Besides, RSI (200) performed better against Naive in terms of
the Calmar ratio, although it fell short in terms of the Sharpe ratio. RR (0.5, 0.5) did even better,
achieving a return of 6.57% p.a., outperforming MKT on a performance basis. However, it still
underperformed Naive on a risk-adjusted basis, as measured by the Sharpe ratio. Note that RSI
(200) and RR (0.5, 0.5) are similar strategies displaying a correlation of 0.987.

The superior performance of the RR (0.5, 0.5) and strong market timing results by Naive
motivated us to combine these two strategies to obtain a more diversified trading signal. Trend
buys or stays long the MKT if Naive and RR (0.5, 0.5) trading signals are unanimously positive.
Otherwise, the strategy switches out of the stock market.

Trend yields an annual return of 5.91%, less than Naive or RR (0.5, 0.5), which is understandable
as it spends less time invested in MKT. On the other hand, it suffers the most favorable maximal
drawdown of -42.87%, exhibits the lowest volatility of 11.63% p.a., and displays one of the
highest risk-adjusted returns.

At this point, we realized that in order to further improve our market timing model, we have to
look beyond price indicators. Therefore, in our next step, we attempt to combine trading signals
of our best-performing strategies in terms of risk-adjusted returns, Naive and Trend, with trading
signals based on macroeconomic indicators.

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Table 1: Performance summary of price-based market timing strategies for the period from
April 1927 to June 2022. The best-performing strategies are shaded.
Ann Ann Max Sharpe Calmar Corr
Strategy Time In
Return Volatility DD Ratio Ratio Naive
MKT 6.56% 18.55% -84.63% 0.35 0.08 100.00% 0.647
Naive 6.30% 12.06% -54.97% 0.52 0.11 67.54% 1.000
MA (50, 200) 5.01% 12.22% -64.63% 0.41 0.08 67.37% 0.877
VOL (50, 200) 3.27% 13.40% -76.88% 0.24 0.04 60.72% 0.571
VOL (200)+,- 2.01% 12.70% -66.71% 0.16 0.03 28.08% 0.314
SKEW (200) 4.04% 13.53% -58.46% 0.30 0.07 71.74% 0.725
RSI (200) 6.40% 13.11% -52.36% 0.49 0.12 70.17% 0.843
RR (0.5, 0.5) 6.57% 13.27% -50.63% 0.50 0.13 71.74% 0.841
Trend 5.91% 11.63% -42.87% 0.51 0.14 63.25% 0.963

Figure 1: Performance chart of price-based market timing strategies for the period from April
1927 to June 2022.

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3 Market Timing Using Trend and Macroeconomic Indicators

In our search for reliable macroeconomic indicators that would improve our market-timing
model, we came upon a blog by Philosophical Economics (2016). Likewise, they attempt to
construct a market timing strategy that would switch from equities (the S&P 500) into cash
(Treasury bills) before each recession and from cash back into equities once the recession is
over. They start with market timing based on the SMA rule and face the exact issue as we do,
i.e., on how to increase the strategy’s risk-adjusted return.

3.1 Conventional Macroeconomic Indicators

Philosophical Economics (2016) suggests that a natural way to enhance the strategy is to teach
it to differentiate between situations where the fundamentals make the recession likely and
situations where the fundamentals make the recession unlikely. Put differently, they propose a
model that would stay invested in equities even if the MA signal is negative, but the
macroeconomic environment is favorable. To quantify the U.S. macroeconomic image, they
consider Real Retail Sales Growth (RSALES) and Industrial Production Growth (INDPROD)
as they represent reliable indicators of the health of the two fundamental segments of the overall
economy: consumption and production.

Their results show that when these macroeconomic signals are used with the MA rule separately,
in both cases, the strategy’s risk-adjusted return improves, albeit the improvement is more
substantial with RSALES. However, the best result emerges when both macro signals are used
jointly, i.e., a strategy that stays invested in equities when the MA signal is positive or both
RSALES and INDPROD signals are jointly positive.

Building upon their findings, we aim to improve our Naive strategy by adding RSALES and
INDPROD signals and achieve results similar to Philosophical Economics (2016). To this end,
we source RSALES and INDPROD data series from the FRED database, which is our primary
source of macroeconomic data. When the obtained data don’t cover our entire sample period,
we use the closest available proxy in the analysis.

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We construct the trading signals for variables RSALES and INDPROD as follows:

▪ RSALES buys or stays long the MKT if Real Retail Sales Growth (YoY) in the prior
month t-1 is positive,
▪ INDPROD buys or stays long the MKT if Industrial Production Growth (YoY) in the
prior month t-1 is positive.

Note that when monthly economic numbers are published, they’re published for the prior
month. Therefore, our macroeconomic signals use the previous month’s economic numbers, not
the current month’s, which are unavailable. Our goal is that macro signals will keep us invested
in the market when the economy is strong, regardless of the minor price fluctuations of MKT.
That means our strategies switch off the stock market only if both trend and macro signals turn
negative. However, only a positive trend signal can force us to return back to the stock market,
a positive macro signal alone is not enough. We apply this condition to all our strategies that
use macroeconomic trading signals.

We add RSALES and INDPROD signals to our Naive strategy separately as well as jointly to
form three strategies following Philosophical Economics (2016). NaiveINDPROD stays long
the MKT if the Naive trading signal is positive or the INDPROD signal is positive.
NaiveRSALES stays long the MKT if the Naive trading signal is positive or the RSALES signal
is positive. NaiveMacro 1 stays long the MKT if the Naive trading signal is positive or
INDPROD and RSALES signals are jointly positive. Otherwise, strategies switch out of the
stock market.

Table 2 displays that all three strategies performed similarly, with NaiveRSALES notching the
highest return of 7.16% p.a. and NaiveMacro 1 exhibiting the highest Sharpe ratio of 0.51. Our
results from Table 2 indicate that adding macro signals to the Naive strategy significantly
improves its return but at the cost of higher volatility and drawdowns, resulting in lower risk-
adjusted returns. We can observe the performance of our strategies in Figure 2 as well, showing
that their equity curves move jointly almost the entire sample period, except for the
NaiveINDPROD in 1960-1990 and the early 2000s. Overall, our results are consistent with
those of Philosophical Economics (2016) and confirmed that some macroeconomic indicators
contain valuable information about future stock market returns, so we continued our search for
novel and reliable macroeconomic indicators that could further improve our model.

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Table 2: Performance summary of market timing strategies by Philosophical Economics for the
period from April 1927 to June 2022. MKT and Naive are added as benchmarks. The best-
performing strategy is shaded.
Ann Ann Max Sharpe Calmar Corr
Strategy Time In
Return Volatility DD Ratio Ratio Naive
NaiveINDPROD 6.86% 14.66% -58.00% 0.47 0.12 88.19% 0.820
NaiveRSALES 7.16% 14.42% -58.00% 0.50 0.12 85.04% 0.833
NaiveMacro 1 7.13% 14.08% -58.00% 0.51 0.12 82.76% 0.853
MKT 6.56% 18.55% -84.63% 0.35 0.08 100.00% 0.647
Naive 6.30% 12.06% -54.97% 0.52 0.11 67.54% 1.000

Figure 2: Performance chart of market timing strategies by Philosophical Economics for the
period from April 1927 to June 2022.

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3.2 Commodity Indicators

Demand for industrial commodities, e.g., copper, oil, or lumber, relative to the demand for safe-
haven assets such as gold, has traditionally been seen as a leading indicator of global economic
health. Rising demand for industrial commodities relative to gold indicates that the economy is
running at full steam, i.e., expansion, implying higher returns for the stock market. Conversely,
falling demand for industrial commodities relative to gold points to a slowdown in production,
suggesting that the economy may be slipping into recession, which in turn leads to lower stock
market returns.

In his paper, Gayed (2015) showed that the relative performance of lumber to gold contains a
significant predictive power that can be utilized in market timing. He explains that when lumber
outperforms gold, equities tend to exhibit an upward bias and have lower volatility, making it
favorable to take more risk in a portfolio. As gold outperforms lumber, the opposite tends to be
true, whereby moving into low-risk assets increases overall return and lowers volatility. His
trading strategy, which switches on a weekly basis from Treasuries to stocks when lumber
outperforms gold and from stocks back to Treasuries when gold outperforms lumber, improves
both absolute and risk-adjusted return metrics relative to simply buying and holding an equity
index. In a similar study, Fang (2020) examined the ability of ten gold price ratios, defined as
the dollar price of gold to the price of an individual asset, to predict aggregate stock returns. He
found that seven out of ten gold price ratios significantly predict stock returns. Among these
ratios, the gold-to-oil ratio is the most powerful return predictor, whose information does not
overlap with the information contained in traditional predictors and other gold price ratios.

Building upon these findings, we construct three trading signals based on the performance of
an industrial commodity versus gold as follows:

▪ COPGLD buys or stays long the MKT if the copper three-month performance is greater
or equal to the gold three-month performance,
▪ OILGLD buys or stays long the MKT if the oil three-month performance is greater or
equal to the gold three-month performance,
▪ LUMGLD buys or stays long the MKT if the lumber three-month performance is greater
or equal to the gold three-month performance.

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Note that although these are macroeconomic signals, they are calculated from commodity
prices, which are available at any time and don’t have to be lagged by one month as our other
macroeconomic signals. We add the constructed trading signals to our Naive strategy and obtain
three commodity strategies. NaiveCOPGLD stays long the MKT if the Naive trading signal is
positive or the COPGLD signal is positive. NaiveOILGLD stays long the MKT if the Naive
trading signal is positive or the OILGLD signal is positive. NaiveLUMGLD stays long the MKT
if the Naive trading signal is positive or the LUMGLD signal is positive. Otherwise, strategies
switch out of the stock market.

We can observe the performance of our commodity strategies in Table 3. The best-performing
commodity strategy in terms of absolute and risk-adjusted returns, NaiveCOPGLD, exhibits an
annual return of 6.97% and a Sharpe ratio of 0.54, which is greater than that of Naive.
NaiveLUMGLD, on the other hand, displays the lowest annual volatility of 12.84% and the
most favorable maximal drawdown of -54.97%. Although some commodity strategies managed
slightly improve Naive’s risk-adjusted returns, they suffer substantial drawdowns, which are
unacceptable in a market timing strategy.

3.3 Unemployment and Dividend Indicators

In our next course of action, we return to the NaiveMacro 1 strategy proposed by Philosophical
Economics (2016) and try to improve it by introducing new macroeconomic trading signals. To
this end, we source the U.S. unemployment rate data series from FRED and S&P Composite
dividends series from Robert Shiller’s website. We construct the trading signals for our new
macroeconomic variables as follows:

▪ UNRATE buys or stays long the MKT if the U.S. unemployment rate by the Bureau of
Labor Statistics in the prior month t-1 falls or remains the same compared to month t-2,
▪ DIVIDEND buys or stays long the MKT if real S&P Composite dividends per share in
the prior month t-1 increase compared to the month t-2.

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Our macroeconomic signals UNRATE and DIVIDEND are inspired by Philosophical
Economics (2016), which uses employment growth and real S&P 500 EPS growth in their
market timing strategy. We prefer to use the UNRATE signal instead of employment growth as
it has a longer data series, making it more reliable. Additionally, it is a more closely watched
indicator by investors. Similarly, we prefer using the DIVIDEND signal instead of real S&P 500
EPS growth. Dividends represent an actual payout to an investor for holding the shares, making
them a more tangible and reliable indicator of economic performance.

In their blog, Philosophical Economics (2016) explain that although both employment growth
and real S&P 500 EPS growth are lagging indicators of recession, they can work well when
used jointly with a trend signal. It is because their main role is to keep strategy invested in the
stock market when the economy is strong. Their study shows that both indicators improve
market timing results by the SMA rule but not as much as INDPROD or RSALES. Note that
their blog uses employment growth and real S&P 500 EPS growth with the MA rule only
separately. We fill this gap and use our UNRATE and DIVIDEND signals with Naive separately
as well as jointly with all our other macro signals.

Our NaiveUNRATE strategy stays long the MKT if the Naive trading signal is positive or the
UNRATE signal is positive. NaiveDIVIDEND stays long the MKT if the Naive trading signal is
positive or the DIVIDEND signal is positive. NaiveMacro 2 stays long the MKT if the Naive
trading signal is positive or INDPROD, RSALES, UNRATE, and DIVIDEND signals are jointly
positive. TrendMacro 1 stays long the MKT if the Trend trading signal is positive or INDPROD,
RSALES, UNRATE, and DIVIDEND signals are jointly positive. Otherwise, strategies switch
out of the stock market.

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Table 3 reports the results. The introduction of UNRATE and DIVIDEND signals improved our
market timing results as our new strategies did substantially better compared to commodity
trading strategies as well as those proposed by Philosophical Economics (2016).
NaiveDIVIDEND displays the highest annual return of 7.64% so far and the highest Sharpe
ratio of 0.57. However, this exceptional performance is at the cost of a sharp maximal
drawdown of -59.10%. NaiveUNRATE and NaiveMacro 2 show similar results, although
NaiveMacro 2 exhibits a little lower volatility as it relies on multiple macroeconomic trading
signals. Our final macro strategy, TrendMacro 1, does exactly what a solid market timing
strategy should do. In the introduction, we mentioned that the ultimate goal of market timing is
to realize market returns at lower volatility and milder drawdowns. Our strategy exhibits an
annual return of 6.45%, close to that of MKT while cutting the volatility by a third to 11.93%
p.a. and maximal drawdown by half to -42.87%. Nevertheless, its Sharpe ratio at 0.54 is slightly
lower when compared with some of our other macroeconomic strategies.

Although TrendMacro 1 shows superior results, there is still room for improvement. Figure 3
shows that strategy (muted brown line) correctly exits MKT during bear markets. It is because
the strategy switches out of the stock market after the Trend signal turns negative, assuming
that at least one of its macro signals is also negative. However, by the time that happens, it can
cumulate a significant amount of losses. For example, during the Wall Street Crash of 1929, the
strategy exits the stock market for the first time when it is already down nearly 25% from its
peak. Naturally, a trading signal that could switch the strategy off the stock market before the
bear market even starts can substantially improve its performance. The good news is that
academic literature knows one reliable indicator that can herald a looming bear market, which
is the yield curve.

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Table 3: Performance summary of macroeconomic market timing strategies for the period from
April 1927 to June 2022. MKT and Naive are added as benchmarks. The best-performing
strategy is shaded.
Ann Ann Max Sharpe Calmar Corr
Strategy Time In
Return Volatility DD Ratio Ratio Naive
NaiveCOPGLD 6.97% 12.91% -60.20% 0.54 0.12 74.93% 0.931
NaiveOILGLD 6.57% 13.67% -60.20% 0.48 0.11 79.93% 0.880
NaiveLUMGLD 6.34% 12.84% -54.97% 0.49 0.12 73.44% 0.939
NaiveUNRATE 7.01% 12.98% -54.97% 0.54 0.13 75.15% 0.926
NaiveDIVIDEND 7.64% 13.51% -59.10% 0.57 0.13 79.00% 0.888
NaiveMacro 2 7.07% 12.45% -54.97% 0.57 0.13 70.78% 0.966
TrendMacro 1 6.45% 11.93% -42.87% 0.54 0.15 66.14% 0.937
MKT 6.56% 18.55% -84.63% 0.35 0.08 100.00% 0.647
Naive 6.30% 12.06% -54.97% 0.52 0.11 67.54% 1.000

Figure 3: Performance chart of macroeconomic market timing strategies for the period from
April 1927 to June 2022.

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4 Market Timing Using Yield Curve

The term yield curve refers to the relationship between the short- and long-term interest rates
of fixed-income securities issued by the U.S. Treasury. Under normal circumstances, the yield
curve slopes upwards since debt with longer maturities typically carries higher interest rates
than nearer-term ones. An inverted yield curve occurs when short-term interest rates exceed
long-term rates. From an economic perspective, an inverted yield curve is noteworthy and
uncommon because it suggests that the near-term is riskier than the long-term.

The slope of the yield curve is influenced by monetary policy and investor expectations. Rising
short-term rates due to expansionary monetary policy could lead to a slowdown in economic
activity and demand for credit as borrowing becomes more expensive. At the same time,
slowing activity may result in lower inflation, increasing the likelihood of a future monetary
policy easing. This expectation of future rate cuts can lead to an inversion of the yield curve as
investors anticipate lower interest rates in the future. This scenario explains the observed
correlation between the yield curve and recessions.

Extensive literature has developed in support of the yield curve as a reliable predictor of
recessions and equity bear markets. Estrella and Mishkin (1996) analyzed the predictive power
of the yield curve to forecast recessions in the timespan from the first quarter of 1960 to the
first quarter of 1995. To this end, they construct a probit model that translates the steepness of
the yield curve at the present time into a likelihood of a recession one, two, four, or six quarters
ahead. They measure the steepness by the spread between the ten-year Treasury rate and the
three-month Treasury rate as this combination of rates is accurate and robust in predicting U.S.
recessions over long periods. They compared its forecasting performance with other indicators
such as the New York Stock Exchange stock price index, the Commerce Department’s index of
leading economic indicators, and the Stock-Watson index. The yield curve outperformed all
indicators in predicting recessions two or more quarters ahead, with no wrong signal and the
best performance four quarters ahead. Therefore, they conclude that the Treasury spread is
useful in macroeconomic prediction, particularly with a longer lead.

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Figure 4: Probability of U.S. recession four quarters ahead predicted by the yield curve or
NYSE stock price index from Q1 1971 to Q1 1995. Shaded areas indicate periods designated
as national recessions by the NBER.

Source: Estrella and Mishkin (1996)

Based on the findings of Estrella and Mishkin (1996), Resnick and Shoesmith (2002) extend
the probit model to forecast equity bear markets in the U.S. For the timespan from January 1971
through December 1999, they use the probit model with the spread between the 10-year and 3-
month Treasuries as the explanatory variable. Their model forecasts a bear market one and two
months in advance, with one-month results being preferable. A simulation using the out-of-
sample time series of probabilities for a stock bear market showed that using a 50% probability
threshold, an investor could outperform the S&P 500. While the buy-and-hold strategy on the
S&P 500 would have gained a compounded return of 14.17% annually, a strategy in which the
investor switched from T-bills to the S&P 500 if the probability of a bear market one month
later was less than 50% and vice versa gained annually 16.46% and hence outperforming the
benchmark by 229 basis points.

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Figure 5: S&P 500 and probability of a bear stock market from January 1971 to
December 1999. Shaded regions indicate five S&P 500 bear markets in this period.

Source: Resnick and Shoesmith (2002)

Building upon the superior predictive results of the yield curve for the U.S. recessions and
equity bear markets in the academic literature, we first add the yield curve signal to our Naive
and Trend strategies. Our trading signal for the yield curve is as follows:

▪ YC buys or stays long the MKT if the 10-year Treasury yield is greater than the 3-month
Treasury yield.

Accordingly, NaiveYC buys or stays long MKT if the Naive trading signal and YC signal are
jointly positive. TrendYC buys or stays long MKT if the Trend trading signal and YC signal are
jointly positive. Otherwise, strategies switch out of the stock market. In both cases,
incorporating the YC signal into the strategy boosted the risk-adjusted returns, as indicated in
Table 4. Naive’s Sharpe ratio grew from 0.52 to 0.55 and the Calmar ratio from 0.11 to 0.15.
The Trend’s improvement was less pronounced as its Sharpe ratio rose from 0.51 to 0.54 and
the Calmar ratio from 0.14 to 0.15. Note that both strategies exhibit results similar to
TrendMacro 1 using just two trading signals, highlighting the superior predictive power of the
yield curve.

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Next, we include the YC signal among macroeconomic indicators in our NaiveMacro 2 and
TrendMacro 1 strategies to obtain their two enhanced versions. NaiveMacro 3 stays long MKT
if the Naive trading signal is positive or INDPROD, RSALES, UNRATE, DIVIDEND, and YC
signals are jointly positive. TrendMacro 2 stays long MKT if the Trend trading signal is positive
or INDPROD, RSALES, UNRATE, DIVIDEND, and YC signals are jointly positive. Otherwise,
strategies switch out of the stock market.

The resultant strategies NaiveMacro 3 and TrendMacro 2 in Table 4 show the exact results as
their counterparts NaiveMacro 2 and TrendMacro 1 in Table 3 since they are equivalent. In this
case, including the YC signal did not make any difference. It is because the only way YC can
affect the strategy’s performance is when it turns negative before any other macroeconomic
signal under the assumption that the trend signal is also negative. Note that our strategies switch
off the stock market only if both trend and macro signals turn negative. However, YC mostly
turns negative even before the trend indicators, forecasting an impending bear market, and then
turns positive once the bear market starts (even before trend indicators turn negative) as the
central bank cuts rates. It is because the yield curve is a leading indicator of a bear market, while
our other macroeconomic indicators are lagging indicators.

Figure 6: Spread between the 10-year Treasury yield and the 3-month Treasury yield from April
1927 to June 2022. Shaded areas indicate bear markets in this period.

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Figure 6 shows that the Treasury spread turned negative before every major bear market during
our sample period as did before the Wall Street Crash of 1929, the 1973–1974 stock market
crash, the Early 1980s recession, the Dot-com bubble in the early 2000s, the 2007–2008
financial crisis, and the 2020 stock market crash.

4.1 The Final Strategy

To fully utilize the YC’s ability to forecast the bear market before it even starts, we drop it from
our macroeconomic predictors and use its signal jointly with Trend instead.

The trading rule for our final strategy is as follows: TrendYCMacro stays long MKT if the
Trend and YC trading signals are both positive or INDPROD, RSALES, and DIVIDEND
signals are jointly positive. Otherwise, the strategy switches out of the stock market.

Note that we dropped UNRATE from our macroeconomic predictions as well since it produced
many false signals, dragging down the strategy’s performance. In this setup, the strategy exits
the stock market not only when the Trend signal turns negative but already when YC turns
negative, assuming that at least one of the macro signals is also negative. This allows the
strategy to avoid the initial declines in bear markets because the YC would switch it off even
before the bear market starts and therefore doesn’t have to wait for the Trend to turn negative.
If accidentally, Trend or YC generates a false negative signal, the strategy would stay invested
in the stock market as long as the economy is strong, i.e., INDPROD, RSALES, and DIVIDEND
signals are jointly positive.

Table 4 demonstrates the impressive performance of TrendYCMacro, with an annual return of

7.05% that surpasses both MKT and Naive. The maximum drawdown of -25.13% is the lowest
among all strategies, which is only a third of that of MKT and half of Naive. Additionally, with
an annual volatility of 11.83%, TrendYCMacro has the highest risk-adjusted performance, as
indicated by its highest Sharpe ratio of 0.60 and Calmar ratio of 0.28 among all our strategies.
These results proved that TrendYCMacro outperformed its benchmarks, MKT and Naive, across
all performance metrics. A visual comparison of TrendYCMacro with other market timing
strategies based on the YC signal can be found in Figure 7.

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Table 4: Performance summary of market timing strategies with YC signal for the period from
April 1927 to June 2022. MKT and Naive are added as benchmarks. The best-performing
strategy is shaded.
Ann Ann Max Sharpe Calmar Corr
Strategy Time In
Return Volatility DD Ratio Ratio Naive
NaiveYC 6.25% 11.38% -41.28% 0.55 0.15 62.73% 0.943
TrendYC 5.92% 10.94% -40.37% 0.54 0.15 58.62% 0.905
NaiveMacro 3 7.07% 12.45% -54.97% 0.57 0.13 70.78% 0.966
TrendMacro 2 6.45% 11.93% -42.87% 0.54 0.15 66.14% 0.937
TrendYCMacro 7.05% 11.83% -25.13% 0.60 0.28 65.70% 0.839
MKT 6.56% 18.55% -84.63% 0.35 0.08 100.00% 0.647
Naive 6.30% 12.06% -54.97% 0.52 0.11 67.54% 1.000

Figure 7: Performance chart of market timing strategies with YC signal for the period from
April 1927 to June 2022.

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Figure 8 highlights the remarkable market timing results of our strategy, TrendYCMacro.
During major bear markets, TrendYCMacro effectively exited the stock market, often prior to
the start of the downturn. The most prominent example of this timing ability is its exit in
December 1926, just before the onset of the Wall Street Crash of 1929. The YC signal also
successfully turned the strategy off before other significant market crashes, including the 1973-
1974 stock market crash, the Early 1980s recession, the Dot-com bubble, the 2007-2008
financial crisis, and the 2020 stock market crash.

Figure 8: Performance chart of TrendYCMacro strategy for the period from April 1927 to June
2022. Shaded areas indicate bear markets.

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Figure 9 shows that our final market timing strategy has experienced a low level of volatility,
with drawdowns rarely exceeding 15%, comparable to the stability offered by traditional bonds.
And although TrendYCMacro suffered a maximum drawdown of -25.13% in October 1987
during Black Monday, it is worth noting that timing such an event with a monthly market timing
strategy is inherently challenging.

Figure 9: Drawdown chart of TrendYCMacro strategy for the period from April 1927 to June
2022. Shaded areas indicate bear markets.

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5 Conclusion

Our goal was to construct a market timing strategy that would reliably sidestep the equity
market during bear markets and thereby reduce market volatility and boost risk-adjusted
returns. In the first part of the paper, we attempted to time the market using price-based
indicators, i.e., moving averages, volatility, skewness, RSI, and Rachev ratio. Among these
indicators, only trading signals from the 200-day SMA, used in our Naive strategy, and an
alternative performance metric Rachev ratio delivered satisfactory results, so we combined
them to obtain a more diversified signal, Trend.

In the second part, inspired by Philosophical Economics (2016), we introduced macroeconomic

trading signals to our Naive and Trend strategies with the aim of improving their risk-adjusted
returns. Our set of macroeconomic indicators included conventional macroeconomic indicators,
such as Real Retail Sales Growth and Industrial Production Growth, commodity indicators
reflecting industrial commodity vs. gold performance, and finally, unemployment and dividend
indicators. Our notion was that trading signals based on macroeconomic indicators would keep
us invested in the market when the economy is strong, regardless of the stock market
fluctuations, reducing unnecessary exits of our strategies. And while the commodity trading
signals failed accurately predict bear markets, the inclusion of the conventional indicators, and
unemployment and dividend indicators significantly improved the absolute and risk-adjusted
returns of our strategies. Our best-performing macroeconomic strategy, TrendMacro 1, which
uses Trend signal as a trend indicator and INDPROD, RSALES, UNRATE, and DIVIDEND
signals as macroeconomic indicators, reduced market volatility by a third and the maximal
drawdown by half.

In the third part, we incorporated information from the yield curve, i.e., the yield spread between
10-year Treasuries and 3-month Treasuries, into our macroeconomic strategies as it is a
recognized and reliable leading indicator of recessions and equity bear markets. Although
adding a YC signal among the macroeconomic predictors did not lead to any improvement, the
use of the YC jointly with trend signals boosted risk-adjusted returns and substantially reduced
drawdowns. Our final strategy, TrendYCMacro, which stays long MKT if the Trend and YC
trading signals are both positive or INDPROD, RSALES, and DIVIDEND signals are jointly
positive, yields an annual return well above that of MKT while doubling its Sharpe ratio and
reducing maximal drawdown by two thirds.

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6 References

[1] Estrella, Arturo and Mishkin, Frederic S., The Yield Curve as a Predictor of U.S.
Recessions (June 1996). Current Issues in Economics and Finance, Vol. 2, No. 7, June
1996, Available at SSRN: https://ssrn.com/abstract=1001228 or
http://dx.doi.org/10.2139/ssrn.1001228
[2] Faber, Meb, A Quantitative Approach to Tactical Asset Allocation (February 1, 2013). The
Journal of Wealth Management, Spring 2007, Available at SSRN:
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[3] Fang, Tong, Gold Price Ratios and Aggregate Stock Returns (September 9, 2020).
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http://dx.doi.org/10.2139/ssrn.3950940
[4] Gayed, Michael, Lumber: Worth Its Weight in Gold Offense and Defense in Active
Portfolio Management (May 8, 2015). 2015 NAAIM Founders Award Winner Updated
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http://dx.doi.org/10.2139/ssrn.2604248
[5] Philosophical Economics, Growth and Trend: A Simple, Powerful Technique for Timing
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[6] Resnick, Bruce and Shoesmith, Gary, Using the Yield Curve to Time the Stock Market
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https://www.researchgate.net/publication/247883838
[7] Siegel, Jeremy, Stocks for the Long Run, New York: McGraw Hill, 2008. 417pp, ISBN
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[8] Stoyanov, Stoyan Veselinov and Rachev, Svetlozar and Fabozzi, Frank J., Optimal
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[9] Zakamulin, Valeriy and Giner, Javier, Trend Following with Momentum Versus Moving
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