Timing the Value Style Index in a Markov Regime-Switching Model

Hany Guirguis, Ted Theodore and Michael Suen

Volume 10, Number 1, First Quarter 2012

We construct and test a popular indicator for timing value style investment: the earnings yield dispersion (EYD). Conventional wisdom holds that one should invest in value style when there is a wide dispersion in earnings yield (E/P ratios) across the equity market. This hypothesis is based on a simple argument: many value stocks are depressed during such periods, causing yields to increase and the earnings yield dispersion (EYD) to widen. Investors believe that depressed prices are bound to revert upward, causing the dispersion to narrow. Using a Markov regime-switching model, we demonstrate that the effect of an EYD signal is conditional on the market regime. In a low-variance regime, an increase in EYD predicts positive returns for the value style index, as suggested by the conventional wisdom. In a high-variance regime, however, an increase in EYD predicts negative returns for the value style index. High-variance regimes tend to be associated with strong negative price momentum and overreacting, pessimistic investors. Thus, it is very difficult for depressed value stocks to bounce back in a high-variance regime. The effect of EYD during a high-variance regime is exactly opposite to the conventional wisdom prediction.