Dreaming the impossible dream?

Market Timing"
Aswath Damodaran

Aswath Damodaran! 1!
 The Payoff to Market Timing"

In a 1986 article, a group of researchers raised the shackles of many an active

portfolio manager by estimating that as much as 93.6% of the variation in
quarterly performance at professionally managed portfolios could be explained
by the mix of stocks, bonds and cash at these portfolios.

In a different study in 1992, Shilling examined the effect on your annual
returns of being able to stay out of the market during bad months. He
concluded that an investor who would have missed the 50 weakest months of
the market between 1946 and 1991 would have seen his annual returns almost
double from 11.2% to 19%.

Ibbotson examined the relative importance of asset allocation and security
selection of 94 balanced mutual funds and 58 pension funds, all of which had
to make both asset allocation and security selection decisions. Using ten years
of data through 1998, Ibbotson finds that about 40% of the differences in
returns across funds can be explained by their asset allocation decisions and
60% by security selection.

Aswath Damodaran! 2!
 The Cost of Market Timing"

In the process of switching from stocks to cash and back, you may miss the
best years of the market. In his article on market timing in 1975, Bill Sharpe
suggested that unless you can tell a good year from a bad year 7 times out of
10, you should not try market timing. This result is confirmed by Chua,
Woodward and To, who use Monte Carlo simulations on the Canadian market
and confirm you have to be right 70-80% of the time to break even from
market timing.

These studies do not consider the additional transactions costs that inevitably
flow from market timing strategies, since you will trade far more extensively
with these strategies. At the limit, a stock/cash switching strategy will mean
that you will have to liquidate your entire equity portfolio if you decide to
switch into cash and start from scratch again the next time you want to be in
stocks.

A market timing strategy will also increase your potential tax liabilities. You
will have to pay capital gains taxes when you sell your stocks, and over your
lifetime as an investor, you will pay far more in taxes.

Aswath Damodaran! 3!
 Market Timing Approaches"

Non-financial indicators, which can range the spectrum from the

absurd to the reasonable.

Technical indicators, such as price charts and trading volume.

Mean reversion indicators, where stocks and bonds are viewed as
mispriced if they trade outside what is viewed as a normal range.

Macro economic variables, such as the level of interest rates or the
state of the economy.

Fundamentals such as earnings, cash flows and growth.

Aswath Damodaran! 4!
 I. Non-financial Indicators"

Spurious indicators that may seem to be correlated with the market but
have no rational basis.

Feel good indicators that measure how happy are feeling - presumably,
happier individuals will bid up higher stock prices.

Hype indicators that measure whether there is a stock price bubble.

Aswath Damodaran! 5!
 1. Spurious Indicators"

There are a number of indicators such as who wins the Super Bowl
that claim to predict stock market movements.

There are three problems with these indicators:

We disagree that chance cannot explain this phenomenon. When you have
hundreds of potential indicators that you can use to time markets, there
will be some that show an unusually high correlation purely by chance.

A forecast of market direction (up or down) does not really qualify as
market timing, since how much the market goes up clearly does make a
difference.

You should always be cautious when you can find no economic link
between a market timing indicator and the market.

Aswath Damodaran! 6!
 2. Feel Good Indicators"

When people feel optimistic about the future, it is not just stock prices
that are affected by this optimism. Often, there are social
consequences as well, with styles and social mores affected by the fact
that investors and consumers feel good about the economy.

It is not surprising, therefore, that people have discovered linkages
between social indicators and Wall Street. You should expect to see a
high correlation between demand at highly priced restaurants at New
York City (or wherever young investment bankers and traders go) and
the market.

The problem with feel good indicators, in general, is that they tend to
be contemporaneous or lagging rather than leading indicators.

Aswath Damodaran! 7!
 3. Hype Indicators"

An example: The cocktail party chatter indicator tracks three measures the
time elapsed at a party before talk turns to stocks, the average age of the
people discussing stocks and the fad component of the chatter. According to
the indicator, the less time it takes for the talk to turn to stocks, the lower the
average age of the market discussants and the greater the fad component, the
more negative you should be about future stock price movements.

As investors increasingly turn to social media, researchers are probing the data
that is coming from these forums to see if they can used to get a sense of
market mood. A study of ten million tweets in 2008 found that a relationship
between the collective mood on the tweets predicted stock price movements.

There are limitations with these indicators

Defining what constitutes abnormal can be tricky in a world where standards and
tastes are shifting.

Even if we decide that there is an abnormally high interest in the market today and
you conclude (based upon the hype indicators) that stocks are over valued, there is
no guarantee that stocks will not get more overvalued before the correction occurs.

Aswath Damodaran! 8!
 II. Technical Indicators"

Past prices

Price reversals or momentum

The January Indicator

Trading Volume

Market Volatility

Other price and sentiment indicators

Aswath Damodaran! 9!
 1a. Past Prices: Does the past hold signs for
the future?"

Aswath Damodaran! 10!

 1b. The January Indicator"

As January goes, so goes the year if stocks are up, the market will be
up for the year, but a bad beginning usually precedes a poor year.

According to the venerable Stock Traders Almanac that is compiled
every year by Yale Hirsch, this indicator has worked 88% of the time.

Note, though that if you exclude January from the years returns and
compute the returns over the remaining 11 months of the year, the
signal becomes much weaker and returns are negative only 50% of the
time after a bad start in January. Thus, selling your stocks after stocks
have gone down in January may not protect you from poor returns.

Aswath Damodaran! 11!

 2a. Trading Volume"

Price increases that occur without much trading volume are viewed as less
likely to carry over into the next trading period than those that are
accompanied by heavy volume.

At the same time, very heavy volume can also indicate turning points in
markets. For instance, a drop in the index with very heavy trading volume is
called a selling climax and may be viewed as a sign that the market has hit
bottom. This supposedly removes most of the bearish investors from the mix,
opening the market up presumably to more optimistic investors. On the other
hand, an increase in the index accompanied by heavy trading volume may be
viewed as a sign that market has topped out.

Another widely used indicator looks at the trading volume on puts as a ratio of
the trading volume on calls. This ratio, which is called the put-call ratio is
often used as a contrarian indicator. When investors become more bearish,
they sell more puts and this (as the contrarian argument goes) is a good sign
for the future of the market.

Aswath Damodaran! 12!

 2b. Money Flow"

Money flow is the difference between uptick volume and downtick volume, as
predictor of market movements. An increase in the money flow is viewed as a
positive signal for future market movements whereas a decrease is viewed as a
bearish signal.

Using daily money flows from July 1997 to June 1998, Bennett and Sias find
that money flow is highly correlated with returns in the same period, which is
not surprising. While they find no predictive ability with short period returns
five day returns are not correlated with money flow in the previous five days
they do find some predictive ability for longer periods. With 40-day returns
and money flow over the prior 40 days, for instance, there is a link between
high money flow and positive stock returns.

Chan, Hameed and Tong extend this analysis to global equity markets. They
find that equity markets show momentum markets that have done well in the
recent past are more likely to continue doing well,, whereas markets that have
done badly remain poor performers. However, they find that the momentum
effect is stronger for equity markets that have high trading volume and weaker
in markets with low trading volume.

Aswath Damodaran! 13!

 3. Volatility"

Figure 12.1: Returns around volatility changes

2.00%

1.50%

1.00%

0.50%

0.00%

Volatility Inceases
-0.50%
Volatility Decreases

-1.00%

-1.50%

-2.00%

-2.50%

-3.00%
In period of change In period after
Return on Market

Aswath Damodaran! 14!

 4. Other Indicators"

Price indicators include many of the pricing patterns that we discussed in

chapter 8. Just as support and resistance lines and trend lines are used to
determine when to move in and out of individual stocks, they are also used to
decide when to move in and out of the stock market.

Sentiment indicators try to measure the mood of the market. One widely used
measure is the confidence index which is defined to be the ratio of the yield on
BBB rated bonds to the yield on AAA rated bonds. If this ratio increases,
investors are becoming more risk averse or at least demanding a higher price
for taking on risk, which is negative for stocks.

Another indicator that is viewed as bullish for stocks is aggregate insider
buying of stocks. When this measure increases, according to its proponents,
stocks are more likely to go up. Other sentiment indicators include mutual
fund cash positions and the degree of bullishness among investment advisors/
newsletters. These are often used as contrarian indicators an increase in cash
in the hands of mutual funds and more bearish market views among mutual
funds is viewed as bullish signs for stock prices.

Aswath Damodaran! 15!

 III. Mean Reversion Measures"

These approaches are based upon the assumption that assets have a
normal range that they trade at, and that any deviation from the normal
range is an indication that assets are mispriced.

With stocks, the normal range is defined in terms of PE ratios.

With bonds, the normal range is defined in terms of interest rates.

Aswath Damodaran! 16!

 1. A Normal Range of PE Ratios"

Aswath Damodaran! 17!

 A normalized earnings version"

Aswath Damodaran! 18!

 2. A Normal Range of Interest Rates"

Using treasury bond rates from 1970 to 1995 and regressing the change in
interest rates ( Interest Ratet) in each year against the level of rates at the end
of the prior year (Interest Ratet-1), we arrive at the following results:

Interest Ratet = 0.0139 - 0.1456 Interest Ratet-1
R2=.0728





(1.29)
(1.81)

This regression suggests two things. One is that the change in interest rates in this period is
negatively correlated with the level of rates at the end of the prior year; if rates were
high (low), they were more likely to decrease (increase). Second, for every 1% increase
in the level of current rates, the expected drop in interest rates in the next period
increases by 0.1456%.

Aswath Damodaran! 19!

 IV. Fundamentals"

The simplest way to use fundamentals is to focus on macroeconomic

variables such as interest rates, inflation and GNP growth and devise
investing rules based upon the levels or changes in macro economic
variables.

Intrinsic valuation models: Just as you value individual companies, you
can value the entire market.

Relative valuation models: You can value markets relative to how they
were priced in prior periods or relative to other markets.

Aswath Damodaran! 20!

 Macroeconomic Variables"

Over time, a number of rules of thumb have been devised that relate
stock returns to the level of interest rates or the strength of the
economy.

For instance, we are often told that it is best to buy stocks when

Treasury bill rates are low

Treasury bond rates have dropped

GNP growth is strong

Aswath Damodaran! 21!

 1. Treasury Bill Rates: Should you buy stocks
when the T.Bill rate is low?"

Aswath Damodaran! 22!

 More on interest rates and stock prices"

A 1989 study by Breen, Glosten and Jagannathan evaluated a strategy of

switching from stock to cash and vice versa, depending upon the level of the
treasury bill rate and conclude that such a strategy would have added about 2%
in excess returns to an actively managed portfolio.

In a 2002 study that does raise cautionary notes about this strategy, Abhyankar
and Davies examine the correlation between treasury bill rates and stock
market returns in sub-periods from 1929 to 2000.

They find that almost all of the predictability of stock market returns comes from
the 1950-1975 time period, and that short term rates have had almost no predictive
power since 1975.

They also conclude that short rates have more predictive power with the durable
goods sector and with smaller companies than they do with the entire market.

Aswath Damodaran! 23!

 2. T. Bond Rates"

Aswath Damodaran! 24!

 Buy when the earnings yield is high, relative to
the T.Bond rate.."

Aswath Damodaran! 25!

 3. Business Cycles and GNP growth"

Aswath Damodaran! 26!

 Real GDP growth and Stock Returns"

Aswath Damodaran! 27!

 Intrinsic Value: Valuing the S&P 500"

On January 1, 2011, the S&P 500 was trading at 1257.64 and the
dividends plus buybacks on the index amounted to 53.96 over the
previous year.

On the same date, analysts were estimating an expected growth rate of
6.95% in earnings for the index for the following five years. Beyond
year 5, the expected growth rate is expected to be 3.29%, the nominal
growth rate in the economy (set equal to the risk free rate).

The treasury bond rate was 3.29% and we will use a market risk
premium of 5%, leading to a cost of equity of 8.29%. (The beta for the
S&P 500 is assumed to be one)

Aswath Damodaran! 28!

 Valuing the index"

We begin by projecting the cash flows on the index, growing the cash
flow (53.96) at 6.95% each year for the next 5 years.

2011 2012 2013 2014 2015
Expected Dividends
plus buybacks= $57.72 $61.73 $66.02 $70.60 $75.51

Incorporating the terminal value, we value the index at 1307.48.

Aswath Damodaran! 29!

 How well do intrinsic valuation models work?"

Generally speaking, the odds of succeeding increase as the quality of your

inputs improves and your time horizon lengthens. Eventually, markets seem to
revert back to intrinsic value but eventually can be a long time coming.

There is, however, a significant cost associated with using intrinsic valuation
models when they find equity markets to be overvalued. If you take the logical
next step of not investing in stocks when they are overvalued, you will have to
invest your funds in either other securities that you believe are fairly valued
(such as short term government securities) or in other asset classes. In the
process, you may end up out of the stock market for extended periods while
the market is, in fact, going up.


The problem with intrinsic value models is their failure to capture permanent
shifts in attitudes towards risk or investor characteristics. This is because so
many of the inputs for these models come from looking at the past.

Aswath Damodaran! 30!

 Relative Valuation Models"

In relative value models, you examine how markets are priced relative
to other markets and to fundamentals.

While it shares some characteristics with intrinsic valuation models,
this approach is less rigid, insofar as it does not require that you work
within the structure of a discounted cashflow model.

Instead, you either make comparisons of markets over time (the S&P
in 2010 versus the S&P in 1990) or different markets at the same point
in time (U.S. stocks in 2010 versus European stocks in 2002).

Aswath Damodaran! 31!

 1. Comparisons across Time"

Aswath Damodaran! 32!

 More on the time comparison"

This strong positive relationship between E/P ratios and T.Bond rates is
evidenced by the correlation of 0.6854 between the two variables. In addition,
there is evidence that the term structure also affects the E/P ratio.

In the following regression, we regress E/P ratios against the level of T.Bond
rates and the yield spread (T.Bond - T.Bill rate), using data from 1960 to 2010.

E/P = 0.0266 + 0.6746 T.Bond Rate - 0.3131 (T.Bond Rate-T.Bill Rate)
R2 = 0.476


(3.37)
(6.41)


(-1.36)

Other things remaining equal, this regression suggests that

Every 1% increase in the T.Bond rate increases the E/P ratio by 0.6746%.
This is not surprising but it quantifies the impact that higher interest rates
have on the PE ratio.

Every 1% increase in the difference between T.Bond and T.Bill rates
reduces the E/P ratio by 0.3131%. Flatter or negative sloping term yield
curves seem to correspond to lower PE ratios and upwards sloping yield
curves to higher PE ratios.

Aswath Damodaran! 33!
 Using the Regression to gauge the market"

We can use the regression to predict E/P ratio in November 2011, with
the T.Bill rate at 0.2% and the T.Bond rate at 2.2%.


E/P2011 = 0.0266 + 0.6746 (.022) - 0.3131 (.022- .02) 
= 0.0408 or 4.08%


PE = 1 =
1
= 24.50

E/P2011 0.0408

Since the S&P 500 was trading at a multiple of 15 times earnings in

November 2011, this would have indicated an under valued market.

Aswath Damodaran! 34!

 2. Comparisons across markets"

Country PE Dividend Yield 2-yr rate 10-yr rate 10yr - 2yr

UK 22.02 2.59% 5.93% 5.85% -0.08%
Germany 26.33 1.88% 5.06% 5.32% 0.26%
France 29.04 1.34% 5.11% 5.48% 0.37%
Switzerland 19.6 1.42% 3.62% 3.83% 0.21%
Belgium 14.74 2.66% 5.15% 5.70% 0.55%
Italy 28.23 1.76% 5.27% 5.70% 0.43%
Sweden 32.39 1.11% 4.67% 5.26% 0.59%
Netherlands 21.1 2.07% 5.10% 5.47% 0.37%
Australia 21.69 3.12% 6.29% 6.25% -0.04%
Japan 52.25 0.71% 0.58% 1.85% 1.27%
United States 25.14 1.10% 6.05% 5.85% -0.20%
Canada 26.14 0.99% 5.70% 5.77% 0.07%

Aswath Damodaran! 35!

 A closer look at PE ratios"

A naive comparison of PE ratios suggests that Japanese stocks, with a

PE ratio of 52.25, are overvalued, while Belgian stocks, with a PE
ratio of 14.74, are undervalued.

There is, however, a strong negative correlation between PE ratios and
10-year interest rates (-0.73) and a positive correlation between the PE
ratio and the yield spread (0.70).

A cross-sectional regression of PE ratio on interest rates and expected
growth yields the following.

PE = 42.62 360.9 (10-year rate) + 846.6 (10-year 2-year ) R2=59%



(2.78)
(-1.42)

(1.08)

Aswath Damodaran! 36!

 Predicted PE Ratios"

Country Actual PE Predicted PE Under or Over Valued

UK 22.02 20.83 5.71%
Germany 26.33 25.62 2.76%
France 29.04 25.98 11.80%
Switzerland 19.6 30.58 -35.90%
Belgium 14.74 26.71 -44.81%
Italy 28.23 25.69 9.89%
Sweden 32.39 28.63 13.12%
Netherlands 21.1 26.01 -18.88%
Australia 21.69 19.73 9.96%
Japan 52.25 46.70 11.89%
United States 25.14 19.81 26.88%
Canada 26.14 22.39 16.75%

Aswath Damodaran! 37!

 An Example with Emerging Markets"

Country PE Ratio Interest Rates GDP Real Growth Country Risk

Argentina 14 18.00% 2.50% 45

Brazil 21 14.00% 4.80% 35
Chile 25 9.50% 5.50% 15
Hong Kong 20 8.00% 6.00% 15
India 17 11.48% 4.20% 25
Indonesia 15 21.00% 4.00% 50
Malaysia 14 5.67% 3.00% 40
Mexico 19 11.50% 5.50% 30
Pakistan 14 19.00% 3.00% 45
Peru 15 18.00% 4.90% 50
Phillipines 15 17.00% 3.80% 45
Singapore 24 6.50% 5.20% 5
South Korea 21 10.00% 4.80% 25

Thailand 21 12.75% 5.50% 25

Turkey 12 25.00% 2.00% 35
Venezuela 20 15.00% 3.50% 45

Aswath Damodaran! 38!

 Estimating Predicted PE ratios"

The regression of PE ratios on these variables provides the following

PE = 16.16 7.94 Interest Rates + 154.40 Real Growth - 0.112 Country Risk



(3.61)
(-0.52)

(2.38)

(-1.78)
R2=74%

Countries with higher real growth and lower country risk have higher
PE ratios, but the level of interest rates seems to have only a marginal
impact. The regression can be used to estimate the price earnings ratio
for Turkey.

Predicted PE for Turkey = 16.16 7.94 (0.25) + 154.40 (0.02) - 0.112
(35) = 13.35

At a PE ratio of 12, the market can be viewed as slightly under valued.

Aswath Damodaran! 39!

 Determinants of Success at using
Fundamentals in Market Timing"

This approach has two limitations:

Since you are basing your analysis by looking at the past, you are
assuming that there has not been a significant shift in the underlying
relationship. As Wall Street would put it, paradigm shifts wreak havoc on
these models.


Even if you assume that the past is prologue and that there will be
reversion back to historic norms, you do not control this part of the
process..

How can you improve your odds of success?

You can try to incorporate into your analysis those variables that reflect
the shifts that you believe have occurred in markets.

You can have a longer time horizon, since you improve your odds on
convergence.

Aswath Damodaran! 40!

 The Evidence on Market Timing"

Mutual Fund Managers constantly try to time markets by changing the

amount of cash that they hold in the fund. If they are bullish, the cash
balances decrease. If they are bearish, the cash balances increase.

Investment Newsletters often take bullish or bearish views about the
market.

Market Strategists at investment banks make their forecasts for the
overall market.

Aswath Damodaran! 41!

 1. Mutual Fund Managers"

While most mutual funds dont claim to do market timing, they

implicitly do so by holding more of the fund in cash (when they are
bearish) or less in cash (when they are bullish).

Some mutual funds do try to time markets. They are called tactical
asset allocation funds.

Aswath Damodaran! 42!

 a. Mutual Fund Cash Positions"

Aswath Damodaran! 43!

 b. Tactical Asset Allocation Funds: Are they
better at market timing?"

Performance of Unsophisticated Strategies versus Asset Allocation Funds

18.00%

16.00%

14.00%

12.00%
Average Annual Returns

10.00%
1989-1998
1994-1998
8.00%

6.00%

4.00%

2.00%

0.00%
S & P 500 Couch Potato 50/50 Couch Potato 75/25 Asset Allocation
Type of Fund

Aswath Damodaran! 44!

 2. Hedge Funds"

A paper looking at the ability of hedge funds to time markets in their

focus groups (which may be commodities, currencies, fixed income or
arbitrage) found some evidence (albeit not overwhelming) of market
timing payoff in bond and currency markets but none in equity
markets.

In contrast, a more recent and comprehensive evaluation of just 221
market timing hedge funds found evidence that a few of these funds
are able to time both market direction and volatility, and generate
abnormal returns as a consequence.

There is also evidence that what separates successful hedge funds from
those that fail is their capacity to adjust market exposure ahead of
market liquidity changes, reducing exposure prior to periods of high
illiquidity. The funds that do this best outperform funds that are dont
make the adjustment by 3.6-4.9% a year after adjusting for risk.

Aswath Damodaran! 45!
 3. Investment Newsletters"

Campbell and Harvey (1996) examined the market timing abilities of

investment newsletters by examining the stock/cash mixes recommended in
237 newsletters from 1980 to 1992.

If investment newsletters are good market timers, you should expect to see the
proportion allocated to stocks increase prior to the stock market going up. When the
returns earned on the mixes recommended in these newsletters is compared to a buy
and hold strategy, 183 or the 237 newsletters (77%) delivered lower returns than
the buy and hold strategy.

One measure of the ineffectuality of the market timing recommendations of these
investment newsletters lies in the fact that while equity weights increased 58% of
the time before market upturns, they also increased by 53% before market
downturns.

There is some evidence of continuity in performance, but the evidence is much
stronger for negative performance than for positive. In other words, investment
newsletters that give bad advice on market timing are more likely to continue to
give bad advice than are newsletters that gave good advice to continue giving good
advice.

Aswath Damodaran! 46!

 Some hope? Professional Market Timers"

Professional market timers provide explicit timing recommendations

only to their clients, who then adjust their portfolios accordingly -
shifting money into stocks if they are bullish and out of stocks if they
are bearish.

A study by Chance and Hemler (2001) looked at 30 professional
market timers who were monitored by MoniResearch Corporation, a
service monitors the performance of such advisors, and found
evidence of market timing ability.

It should be noted that the timing calls were both short term and
frequent. One market timer had a total of 303 timing signals between
1989 and 1994, and there were, on average, about 15 signals per year
across all 30 market timers. Notwithstanding the high transactions
costs associated with following these timing signals, following their
recommendations would have generated excess returns for investors.

Aswath Damodaran! 47!

 4. Market Strategists provide timing advice"

Firm Strategist Stocks Bonds Cash

A.G. Edwards Mark Keller 65% 20% 15%
Banc of America Tom McManus 55% 40% 5%
Bear Stearns & Co. Liz MacKay 65% 30% 5%
CIBC World Markets Subodh Kumar 75% 20% 2%
Credit Suisse Tom Galvin 70% 20% 10%
Goldman Sach & Co. Abby Joseph Cohen 75% 22% 0%
J.P. Morgan Douglas Cliggott 50% 25% 25%
Legg Mason Richard Cripps 60% 40% 0%
Lehman Brothers Jeffrey Applegate 80% 10% 10%
Merrill Lynch & Co. Richard Bernstein 50% 30% 20%
Morgan Stanley Steve Galbraith 70% 25% 5%
Prudential Edward Yardeni 70% 30% 0%
Raymond James Jeffrey Saut 65% 15% 10%
Salomon Smith John Manley 75% 20% 5%
UBS Warburg Edward Kerschner 80% 20% 0%
Wachovia Rod Smyth 75% 15% 0%

Aswath Damodaran! 48!

 But how good is the advice?"

Aswath Damodaran! 49!

 Market timing Strategies"

Adjust asset allocation: Adjust your mix of assets, allocating more

than you normally would (given your time horizon and risk
preferences) to markets that you believe are under valued and less than
you normally would to markets that are overvalued.

Switch investment styles: Switch investment styles and strategies
within a market (usually stocks) to reflect expected market
performance.

Sector rotation: Shift your funds within the equity market from sector
to sector, depending upon your expectations of future economic and
market growth.

Market speculation: Speculate on market direction, using either
borrowed money (leverage) or derivatives to magnify profits.

Aswath Damodaran! 50!

 1. Asset Allocation Changes"

The simplest way of incorporating market timing into investment

strategies is to alter the mix of assets stocks, cash, bonds and other
assets in your portfolio.

The limitation of this strategy is that you will shift part or all of your
funds out of equity markets if you believe that they are over valued
and can pay a significant price if the stock market goes up. If you
adopt an all or nothing strategy, shifting 100% into equity if you
believe that the market is under valued and 100% into cash if you
believe that it is overvalued, you increase the cost of being wrong.

Aswath Damodaran! 51!

 2. Style Switching"

There are some investment strategies that do well in bull markets and
others that do better in bear markets. If you can identify when markets
are overvalued or undervalued, you could shift from one strategy to
another or even from one investment philosophy to another just in time
for a market shift.

Growth and small cap investing do better when growth is low and
when the yield curve is downward sloping.

Kao and Shumaker estimate the returns an investor would have made
if she had switched with perfect foresight from 1979 to 1997 from
value to growth stocks and back for both small cap and large cap
stocks. The annual returns from a perfect foresight strategy each year
would have been 20.86% for large cap stocks and 27.30% for small
cap stocks. In contrast, the annual return across all stocks was only
10.33% over the period.

Aswath Damodaran! 52!

 3. Sector Rotation"

Aswath Damodaran! 53!

 4. Speculation"

The most direct way to take advantage of your market timing abilities
is to buy assets in a market that you believe is under valued and sell
assets in one that you believe is over valued.

It is a high risk, high return strategy. If you are successful, you will
earn an immense amount of money. If you are wrong, you could lose it
all.

Aswath Damodaran! 54!

 Market Timing Instruments"

Futures contracts: There are futures contracts on every asset class:

commodities, currencies, fixed income, equities and even real estate,
allowing you to go either long or short on whichever asset classes that
you choose.

Options contracts: Options provide many of the same advantages that
futures contracts offer, allowing investors to make large positive or
negative bets, with liquidity and low costs.

Exchange Traded Funds (ETFs): Like futures contracts, ETFs do not
require you to pay a time premium to make a market bet. Unlike
options or futures, which have finite lives, you can hold an ETF for
any period you choose.

Aswath Damodaran! 55!

 Connecting Market Timing to Security Selection"

You can be both a market timer and security selector. The same beliefs
about markets that led you to become a security selector may also lead
you to become a market timer. In fact, there are many investors who
combine asset allocation and security selection in a coherent
investment strategy.

There are, however, two caveats to an investment philosophy that
includes this combination.

To the extent that you have differing skills as a market timer and as a
security selector, you have to gauge where your differential advantage
lies, since you have limited time and resources to direct towards your task
of building a portfolio.

You may find that your attempts at market timing are under cutting your
asset selection and that your overall returns suffer as a consequence. If
this is the case, you should abandon market timing and focus exclusively
on security selection.

Aswath Damodaran! 56!