Market Timing & Predictability Quiz
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The following quiz is meant to test your general knowledge of return predictability. The first half of the quiz is meant to test your general knowledge of the topic, and the second half is specific to our approach as outlined in our research paper.
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Question 1 of 8
1. Question
The equity premium is equal to the difference between the S&P 500 returns and the T-bill rate.
Correct
True. The equity premium may also be called the equity risk premium or market excess returns. It is defined as the additional compensation investing in the stock market provides over a risk-free rate, which is often taken to be the Treasury Bill.
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True. The equity premium may also be called the equity risk premium or market excess returns. It is defined as the additional compensation investing in the stock market provides over a risk-free rate, which is often taken to be the Treasury Bill.
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Question 2 of 8
2. Question
The equity premium is always 6%.
Correct
False. There is ample evidence that the equity premium changes throughout the business cycle. It is high in troughs and low in peaks. A non-constant equity premium gives rise to the possibility of changing one’s portfolio based on its prevailing value.
Incorrect
False. There is ample evidence that the equity premium changes throughout the business cycle. It is high in troughs and low in peaks. A non-constant equity premium gives rise to the possibility of changing one’s portfolio based on its prevailing value.
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Question 3 of 8
3. Question
All academics agree that market returns are predictable.
Correct
False. There is a debate among academics on whether returns are predictable. For example, Cochrane (2008) offers a convincing argument in favor of predictability whereas Goyal and Welch (2008) provide a strong argument against it.
Incorrect
False. There is a debate among academics on whether returns are predictable. For example, Cochrane (2008) offers a convincing argument in favor of predictability whereas Goyal and Welch (2008) provide a strong argument against it.
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Question 4 of 8
4. Question
Nobel laureate Robert Merton called attempts to estimate changing equity premiums a “fool’s errand”.
Correct
True! In a 1980 paper, Merton expressed strong opinion against the possibility of good equity premium estimates. However, since then much academic work has demonstrated it is possible to obtain good estimates.
Incorrect
True! In a 1980 paper, Merton expressed strong opinion against the possibility of good equity premium estimates. However, since then much academic work has demonstrated it is possible to obtain good estimates.
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Question 5 of 8
5. Question
“The trend is your friend”. A variable based on the short-term price trend is positively correlated with future returns.
Correct
True. Faber (2007) proposes buy and sell rules based on the relative levels of the current price to the past 10-month average. He finds if the current price level exceeds the average, future market returns are expected to be high.
Incorrect
True. Faber (2007) proposes buy and sell rules based on the relative levels of the current price to the past 10-month average. He finds if the current price level exceeds the average, future market returns are expected to be high.
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Question 6 of 8
6. Question
New orders and shipments have a positive relationship with future returns.
Correct
False. Jones and Tuzel (2012) find that a high ratio of new orders to shipments of durable goods is associated with business cycle peaks and forecast lower excess returns.
Incorrect
False. Jones and Tuzel (2012) find that a high ratio of new orders to shipments of durable goods is associated with business cycle peaks and forecast lower excess returns.
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Question 7 of 8
7. Question
It is possible to form an investment strategy based on equity premium forecasts.
Correct
True. In our paper “A Practitioner’s Defense of Return Predictability”, we illustrate how an investor could implement market-timing strategies based on good return forecasts.
Incorrect
True. In our paper “A Practitioner’s Defense of Return Predictability”, we illustrate how an investor could implement market-timing strategies based on good return forecasts.
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Question 8 of 8
8. Question
In our paper “A Practitioner’s Defense of Return Predictability”, we propose a market-timing strategy that doubles the Sharpe ratio of buy-and-hold.
Correct
False. We can QUADRUPLE the Sharpe ratio of buy-and-hold. Our simulated market-timing strategy earned twice the annualized returns as buy-and-hold, with half of the volatility.
Incorrect
False. We can QUADRUPLE the Sharpe ratio of buy-and-hold. Our simulated market-timing strategy earned twice the annualized returns as buy-and-hold, with half of the volatility.
If you are interested in learning more about our approach to forecasting returns, the following questions relate to our research paper “ A Practitioner’s Defense of Return Predictability”.
Practitioners Defense of Return Predictability
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The following quiz is meant to test your knowledge specific to our approach as outlined in our research paper.
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Question 1 of 9
1. Question
All of the variables used in “A Practitioner’s Defense of Return Predictability” have been proposed in the academic literature.
Correct
True. Our research paper uses 20 variables from the academic literature on return predictability.
Incorrect
True. Our research paper uses 20 variables from the academic literature on return predictability.
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Question 2 of 9
2. Question
Using all of the variables is called a “Kitchen Sink Model”. We always include all 20 variables in the model.
Correct
False. We refit our model every 20 days. On each refit, a predictor may or may not be included depending the strength of its signal. Including only the strongest predictors each time gives superior results compared to including all of the variables.
Incorrect
False. We refit our model every 20 days. On each refit, a predictor may or may not be included depending the strength of its signal. Including only the strongest predictors each time gives superior results compared to including all of the variables.
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Question 3 of 9
3. Question
The market-timing strategy never uses leverage.
Correct
False. When the signal is strong enough, we will use leverage go long more than 100%.
Incorrect
False. When the signal is strong enough, we will use leverage go long more than 100%.
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Question 4 of 9
4. Question
On average, the strategy trades every eight days and is not tax efficient.
Correct
True. Because we change positions frequently, we may realize short-term capital gains that are taxed at a high rate compared to long-term gains. As such, this strategy would fit better in 401K, IRA, or foundation accounts.
Incorrect
True. Because we change positions frequently, we may realize short-term capital gains that are taxed at a high rate compared to long-term gains. As such, this strategy would fit better in 401K, IRA, or foundation accounts.
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Question 5 of 9
5. Question
The maximum drawdown of the market-timing strategy is similar to that of buy-and-hold.
Correct
False. The max drawdown of the market-timing strategy is less than half that of the buy-and-hold in our sample from 2001 to 2015.
Incorrect
False. The max drawdown of the market-timing strategy is less than half that of the buy-and-hold in our sample from 2001 to 2015.
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Question 6 of 9
6. Question
In the four years from 2003 to 2006, the market-timing strategy underperformed buy-and-hold every year.
Correct
True. Although market-timing performs better in the long run, in the short run it can underperform. From 2003 to 2006, buy-and-hold beat market-timing each year.
Incorrect
True. Although market-timing performs better in the long run, in the short run it can underperform. From 2003 to 2006, buy-and-hold beat market-timing each year.
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Question 7 of 9
7. Question
A systematic and disciplined approach will be essential for this strategy to work in the long run.
Correct
True. Since the market-timing strategy could underperform in the short run, the investor must stay disciplined and believe in the model in order to reap the benefits in the long run.
Incorrect
True. Since the market-timing strategy could underperform in the short run, the investor must stay disciplined and believe in the model in order to reap the benefits in the long run.
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Question 8 of 9
8. Question
Implementing the proposed strategy will be easy. The data is publicly available and the system requires almost no effort to set up.
Correct
False. It takes a team of dedicated researchers and traders to set up and implement a market-timing strategy. The paper serves as a simple illustration of how to carry out such a strategy. Our approach for the ETF is more sophisticated and has been refined over several years.
Incorrect
False. It takes a team of dedicated researchers and traders to set up and implement a market-timing strategy. The paper serves as a simple illustration of how to carry out such a strategy. Our approach for the ETF is more sophisticated and has been refined over several years.
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Question 9 of 9
9. Question
If investors took a disciplined and systematic approach to market timing using return predictability, markets would be less volatile.
Correct
True. Market-timing has a “contrarian” spirit. It prescribes for investors to sell when prices are high and expected returns are low, and to buy when prices are low and expected returns are high. Such trading behavior tends to reduce market volatility and stabilize prices.
Incorrect
True. Market-timing has a “contrarian” spirit. It prescribes for investors to sell when prices are high and expected returns are low, and to buy when prices are low and expected returns are high. Such trading behavior tends to reduce market volatility and stabilize prices.