The predictive ability of the yield spread in timing the stock exchange: a South African case

Abstract

The use of the yield curve in forecasting economic recessions is well established in the literature. A new avenue of use for the yield curve has emerged in the form of using it to forecast bull and bear stock markets. This has the potential to change how investors manage portfolios. A dynamic market-timing strategy would allow investors to shift out of or in to stock markets based on the probability of bear stock market in the future. The relationship between the yield curve and the stock market is tested using an adapted probit model. This has proven positive with encouraging results for the US, India and Spain. This is tested for South Africa using the adapted probit model and the SA yield spread. Bear stock markets are identified on the JSE and forms part of the probit modelling process. Bear markets are identified using a six- and four-month criteria. As South Africa is a small, open and developing economy, the probit is also modelled using the US yield spread. The three probit models do not appear to track bear markets well. This is substantiated through the Henriksson-Merton parametric model test which tests for market timing ability. The results for the SA yield spread using both bear market criteria do not show market timing ability, however, the SA and US yield spread model does show potential market timing ability.