LUBS3625: professional portfolio management
Lecture 2: market timing
Chapter 12
Step 1 in portfolio management is asset allocation
Where will you invest how much percentage of your money ?
In different asset classes such as stock , bonds and real assets or different markets or
different industries ??
Usually based on a mean variance portfolio ( risk factor)
Can be equally weighted to each asset class
Or
Market cap weighted portfolio ( weight of asset in portfolio is equal to its market value
divided by total market value of whole portfolio)
This concerns an actively managed portfolio ( aims to outperform certain benchmark
indices)
Non-financial time indicators
• Spurious indicators
• E.g. winner of Super Bowl
• No causality, correlation purely by chance
• Feel-good indicators
• E.g. crowds at expensive nightclubs
• Contemporaneous indicators rather than leading
• Hype indicators
• E.g. how much people talk about stocks on social media
• You know that the market is overvalued, you don’t know when the correction
will occur.
Market timing technical approaches
• Past prices
• Reversal or momentum patterns in prices?
• Works partly for individual company stock prices, not for overall markets.
• Trading volume
• Put/call ratio: investor sentiment measure
• Volatility
• Volatility increase contemporaneous negative but future positive returns
• Caveat: higher future returns may also reflect the fact that stocks
become riskier
• Increase in VIX value and large-cap stocks outperform
Mean reversion indicators
• Market Price-to-earnings (P/E) ratio:
• It is the P/E ratio of the market’s benchmark index: essentially it is the
weighted average P/E ratio of the stocks in the index.
• Some investors believe that there is a normal range for market P/E ratio values:
• Stocks overvalued (undervalued) if P/E above (below) the upper (lower) end
of this range
• Three types of P/E ratios
• Trailing P/E ratio (TTM P/E)
• Market price of a company’s share divided by the company’s EPS over
the past 12 months
• Most popular type in the market
• Objective, but backward-looking
• Forward P/E ratio
• Market price of a company’s share divided by the company’s
forecasted EPS over the next 12 months
• Forward-looking, but forecasts of future earnings subject to analysts’
biases and deliberate misguidance from the company
• Cyclically Adjusted P/E ratio (CAPE or Schiller ratio)
• Market price of a company’s share (or a stock index) divided by the
company’s (or the index companies’) average inflation-adjusted EPS
over the previous 10 years.
• Smooths trailing P/E ratio values, especially during periods of extreme
price or EPS swings
Macro-economic indicators
• Short-term interest rates
• Drop in sort-term interest rates predicts high future stock returns.
• Predictive power has considerably decreased over time.
• Long-term interest rates
• Some investors use the difference between earnings yield and long-term
bond rate as a leading indicator for future stock returns.
• Business cycle
• Market movements are based on predictions about future economic activity.
• Very valuable if you can make successful forecasts for future economic
growth.
• Leading indicators of economic activity: rise or fall before the economy.
Fundamental value indicators
• Intrinsic value models
• Extend DCF models to whole indexes or markets
• Value = expected dividends / (Cost of equity – expected growth rate)
• Sum of dividends of all index stocks
• Cost of equity for the average-risk stock and average growth rate of
index stocks
• Relative value models
• Comparison across markets
• Be careful to take into account differences in fundamentals, e.g. when
comparing P/E ratios of different countries (interest rates, risk, expected
growth)
How to react to timing
• Asset allocation
• Alter the mix of assets (stocks, bonds, cash, and other assets) in your
portfolio Relative value models
• Can be costly works better with long-term timing
• Style switching
• Shift from one strategy to another (e.g. value, growth)
• E.g. Growth stocks outperform when earnings growth is low or when yield
curve is downward sloping.
• Sector rotation
• Switch into different sectors
• E.g. Expectation of higher economic growth cyclical sectors
• E.g. Expectations of higher interest rates switch out of financial stocks
• Sensitivity of firm’s earnings to the business cycle:
• sensitivity of sales (necessities vs. luxury goods)
• financial leverage
• operating leverage
• Speculation
• Sell short an overvalued asset class (market) and buy an undervalued asset
class (market).
• High leverage exaggerates the effect of both success and failure.
