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ABSTRACT

The interaction of interest rates and corporate earnings over the eco- nomic cycle generates stock price movements. These movements are captured in the present valuation context. Superior returns are ob- served when long-term asset allocation techniques are applied to the model.

INTRODUCTION

This research shows that asset allocation among stocks, long-term U.S. Treasury bonds (T-bonds), and Treasury bills (T-bills) based on economic conditions can improve upon buy/hold investment strate- gies [1, 4–6]. Previous research [2, 3] on stock market cycles suggests that interactive changes in corporate profits and interest rates over the economic cycle have opposite effects on stocks and bonds prices. As a result, an asset allocation strategy using percentage changes in interest rates and corporate profits did, in fact, produce superior re- turns.

DATA

The quarterly Standard & Poor’s 400 Industrial Index (S&P 400 Index), its earnings per share, and its dividends constituted the data for stock and earnings calculations. The S&P 400 Index was chosen because its large portion of industrial company stocks generally are considered a good reflection of economic cycles. The bond prices and interest rates used were the 30-year U.S. T-bond. These were chosen to reflect only interest rate changes and to avoid possible default risk

*University of South Florida, Tamps. FL 33620. The authors thank an unknown reviewer for helpful comments.

Table 1

Market Highs and Lows

Year Quarter S&P 400 Index

1967 1 L/ 96.71 1968 4 H/113.02 1970 2 L/ 79.89 1972 4 H/131.87 1974 3 L/ 71.01 1976 3 H/119.46 1978 1 L/ 98.02 1980 4 H/154.45 1982 2 L/122.42 1983 2 H/189.98 1984 2 L/174.73 1987 3 H/375.85 1989 3 397.85

distortions. The 90-day T-bill interest rate was used for short-term rates. The stock market highs and lows were determined using the S&P 400 Index (Table 1).

METHODOLOGY

Four distinct investment strategies were simulated from the end of 1967 to the fourth quarter of 1987. The first study assumed a buy/ hold for the S&P 400 Index. The second strategy assumed a buy/ hold for the 30-year T-bonds. The third strategy assumed a buy/hold of the T-bills reallocated every 90 days. The fourth strategy assumed a quarterly asset allocation based on equation (1).

The S&P 400 Index buy and hold strategy over the 20-year period, reinvesting all dividends, resulted in an average 10.6 percent yearly return. The T-bill strategy, reinvesting interest in capital gains, re- sulted in a 6.1 percent average return. The buy/hold investment strat- egy for the 30-year U.S. T-bonds, including quarterly reinvestment of interest, resulted in a 7.8 percent yearly average return.

The asset allocation strategy, with quarterly reallocation between stocks and long-term bonds, resulted in a 12.9 percent annual return. The reallocation between the two was based on the percentage in-

crease or decrease in the S&P 400 Index earnings and in the interest rates on long-term bonds. The percentage change in the earnings of the prior quarter of the S&P 400 Index, minus the percentage change in the long-term bond interest rate of the prior quarter resulted in a combined change of the two or, as we will call it, a total change:

Total change ⫽ %∆E ⫺ %∆i (1)

where

%∆E ⫽ prior quarter percent change in earnings,

%∆i ⫽ prior quarter percent change in 30-year T-bond yields.

The reallocation at the beginning of each quarter was based on the prior quarter’s total change in equation (1).

As the expansionary part of the business cycle propels earnings upward more rapidly than interest rates, total change is positive, and money is shifted from stocks to bonds. This reallocation continues every quarter in proportion to the total percentage change observed. Reported data on earnings and dividends were not available at more frequent intervals.

Ideally, when the percentage change in earnings growth exactly equals the percentage change in interest rates, the portfolio is entirely in bonds because equities have peaked. The reverse portfolio reallo- cation starts with earnings declining but interest rates declining more rapidly. The result is a negative total percentage change and a shift from bonds to stocks. This captures the dynamic interaction of earn- ings and interest rates in the present discounted value model of stock prices [2].

The reallocation between stocks and bonds is based solely on the prior quarter’s reported percentage change in earnings and interest rates in equation (1). This reallocation method outperformed the mar- ket over the period used in the study. This result was found for both the long-term, original sample and the shorter-term, out-of-sample test. Even though this is a total cycle, the longer-term model and the out- of-sample results were only for two years in a bull market environment, the asset allocation was superior to the buy/hold strategies for stocks and about equal to the bonds, which historically have produced spurts of short-term superior return as in this sample. With perfect hindsight, a 100 percent switching from stocks at the equity highs into T-bills

then into bonds at the peak in economic activity and back into stocks at the market lows had the highest return, 15.7 percent before commis- sions, as expected from hindsight. The 12.9 percent pre-commission return is not based on hindsight and still outperforms the buy and hold of stocks, T-bills, or long-term T-bonds by themselves. We suggest that the 100 percent hindsight model cannot be implemented and rec- ommend the asset allocation strategy based on the total percentage change indicator of equation (1).

The asset allocation model, which produced superior returns, may have lower risk. We are dealing only with systematic risk in stocks by using the S&P 400 Index. Intuitively, we cannot reduce the sys- tematic stock risk; it is already a fully diversified portfolio of 400 stocks. We have no default risk in the U.S. government securities, the other assets.

The risk is a short-term, large whipsaw move in the assets’ prices from quarter to quarter, not in the traditional systematic or unsys- tematic measures of risk. Fortunately economic cycles for which this allocation strategy is designed tend not to whipsaw so dramatically. The model is designed as a long-term portfolio strategy over the entire cycle including recession and expansion.

TRANSACTIONS COSTS

The transactions costs associated with this asset allocation strategy are relatively low. These low transactions costs are the natural result of reallocation only quarterly, the homogeneity of the securities used, the efficiency of financial markets, the mechanical nature of the al- location rules, and the ready availability of noload S&P Index and U.S. T-bond mutual funds with switching privileges.

The S&P Index and the U.S. Treasuries used in the allocation are homogeneous securities offered by several low-cost providers such as Vanguard. Many have historically closely tracked the securities. De- mand will naturally move toward the least cost provider in an efficient market of homogeneous products. The impact of transactions costs will therefore approximate the administrative costs borne by investors in these no-load funds. Applying the observed .25 percent to .50 per- cent annual expense fee still keeps the return to the asset allocation strategy superior to that of the buy/hold approach.

percentage change in equation (1). The impact of transactions costs on the annual return would be modest.

All but the largest investors might use no-load index or other mu- tual funds switching techniques at no transactions costs. They would bear management and administration fees. The largest investors typ- ically negotiate relatively low commissions.

CONCLUSIONS

Based solely on the historical percentage change in earnings and interest rates in the prior quarter, the asset allocation strategy pro- duced a 12.9 percent return. The asset allocation model based on the total change indicator of equation (1) is suggested as an appropriate portfolio management tool for achieving potentially superior returns. This was above the stock buy/hold strategy return of 10.6 percent for the first quarter of 1967 through the fourth quarter of 1987. We conclude that dynamic asset allocation based on the interactive move- ments of earnings and interest rates is a viable technique for poten- tially superior investment performance.

REFERENCES

[1] Admati, Anat R., Sudipto Bhattacharya, Paul Pfleiderer, and Stephen A. Ross. “On Timing and Selectivity.” Journal of Finance 41 (July 1986): 715–732.

[2] Bolten, Steven E. “Cycle Exegesis.” Financial Planning (November 1985): 208–210.

[3] Bolten, Steven E., and Susan W. Long. “A Note on Cyclical and Dy- namic Aspects of Stock Market Price Cycles.” The Financial Review 21 (February 1986):145–150.

[4] Farrell, James L., Jr. “A Fundamental Forecast Approach to Superior Asset Allocation.” Financial Analysts Journal 45 (May/June 1989):32– 37.

[5] Ferguson, Robert. “How to Beat the S&P 500 (Without Losing Sleep).”

Financial Analysts Journal 42 (March/April 1989):37–46.

[6] Perold, Andre F., and William F. Sharpe. “Dynamic Strategies for Asset Allocation.” Financial Analysts Journal 44 January/February 1988): I6ff.