Market Timing Money Machine

Set it and forget it…or just forget it?

by Peter Girolamo, C.P.A., M.B.A.

Aaah the lure of timing the market: Knowing when to buy at a low point and when to sell at a high point. The problem is, of course, determining a market low or a high is virtually impossible.

Or is it?

Back in 1997 the Federal Reserve Board made an interesting assertion to Congress. The Fed determined that from 1982 to 1997 earnings yield on the S&P500 (specifically, next year’s earnings as a percentage of the value of the S&P500) was similar to the yield on 10 year treasury notes. This concept has become known as the "Fed Model."

But how does this relate to market timing?

The theory here is, if there is a strong long-term correlation between the S&P500 earnings yield and the 10 year treasury yield, an investment or arbitrage opportunity would exist when the yields differ. Equities could be over- or undervalued relative to 10 year treasuries. Therein lies the opportunity, if you believe the Fed Model.

So where’s the money machine?

If you were a dedicated investor with a lot of time on your hands, and you buy in to the Fed Model, you could track these yields and move money back and forth between an S&P500 index investment to 10 year treasuries, as the yields move. Seems like a lot of work.

There could be an easier way. We are starting to see alternative investments based on the Fed Model. When stocks look overvalued according to the Fed Model, the invested monies are automatically moved to bonds (based on defined triggers built into the investment methodology). Similarly, when stocks look undervalued according to the Fed Model, more money is moved into equity investments. If the Fed Model is correct, and the investment vehicle replicated the Fed Model accurately, an investor would be protected from market aberrations to some extent.

Proceed with caution

These alternative investments sometimes modify the Fed Model. For example, it may use an S&P500 index investment and a bond investment, but not necessarily 10 year treasuries. By doing so, results could be at variance with the Fed Model.

Now, before you pick up the phone to call your financial adviser, be aware that there is significant debate over whether the Fed Model is real or flawed. For example, the model uses estimates of future earnings, and estimates are not necessarily correct. Other criticisms are that the Fed Model assumes that the S&P500 is representative of the stock market, it may not be, and the effects of inflation are not considered. As with any investment decision, be sure to understand the risks and potential returns before investing.

Peter Girolamo, CPA specializes in bookkeeping, payroll, tax services and related advice for small businesses and their owners. His office is located in Thousand Oaks California, but he serves clients in several states. Peter can be reached or by phone at 805-778-9277.