Market Timing of International Stock Markets using the Yield Spread

Abstract

There has been much interest in recent years in the ex ante equity risk premium. Empirical studies indicate that it is possible for the ex ante equity risk premium to be negative and that it is related to an inverted yield curve of government bonds. This finding holds for the U.S. marketplace and for large foreign economies. Additionally, smaller countries have negative risk premiums in periods preceded by inverted U.S. yield curves. However, it remains an empirical question whether investors can form profitable trading strategies based on the relationship between the equity risk premium and the yield curve. The present study extends recent probit modeling by Estrella and Mishkin (1996, 1998) for forecasting an economic recession. Specifically, we use the yield curve spread to forecast a bear stock market (negative ex ante market risk premium) in the U.S and eight major foreign stock markets. In general, it is found that the U.S. yield spread contains more important market timing information than does the home country yield spread for profitable market timing. The findings hold from the perspective of the local currency investor and the U.S. dollar investor investing in foreign stock markets. Overall our results support the possibility of a negative ex ante risk premium.