Time-Varying Sharpe Ratios and Market Timing

Abstract

This paper documents predictable time-variation in stock market Sharpe ratios. Predetermined financial variables are used to estimate both the conditional mean and volatility of equity returns, and these moments are combined to estimate the conditional Sharpe ratio. In sample, estimated conditional Sharpe ratios show substantial time-variation that coincides with the variation in ex post Sharpe ratios and with the phases of the business cycle. Generally, Sharpe ratios are low at the peak of the cycle and high at the trough. In out-of-sample analysis, using 10-year rolling regressions, we can identify periods in which the ex post Sharpe ratio is approximately three times larger than it full-sample value. Moreover, relatively nave market-timing strategies that exploit this predictability can generate Sharpe ratios more than 70% larger than a buy-and-hold strategy.