Friday, 9 December 2016

Market Timing Theory


Market timing theory is one of most important theories evolved for capital structure of the firm. Firms have two main ways to finance their business either through equity or debt financing. In 2002, Bakers and Wurgler introduced Market timing theory.  Their study claims that the Market timing is the primary request determinant of a company's capital structure for the utilization of equity & debt. Firms are only concerned with those ways which gives them higher opportunity of profits. Market timing is a dimension of Behavioral Finance which depicts firm’s tactics towards market fluctuation. This theory proposes that Managers can help the best for the firm to lower its cost of capital. Equity issuance at the time of high valuation is very beneficial to the firm. Baker and Wurgler finds that low influential firms are those that raised assets when their market valuations were high, as measured by the market-to-book proportion .On the other hand high influential firms are those which raised assets when their market valuations were low. This additionally suggests, for outside financing decisions, firms lean toward outer value when the cost of equity is low then they favor debt sources. Firm’s techniques towards market timing ultimately affects capital structure of that particular company.

Since 1977, timing behavior of firms were indirectly tested. Till 2001, a proper theory was not introduced. (Hovakimian, Opler, and Titman 2001), (Pagano, Panetta, and Zingales 1998), (Bayless and Chaplinsky 1996), (Rajan and Zingales 1995), (Choe, Masulis, and Nanda 1993), (Asquith and Mullins 1986), (Jalilvand and Harris 1984), (Marsh 1982) and (Taggart 1977) indirectly tested the timing behavior of firms. In these studies Market to book ratios and debt to equity ratios were also used as variables. Basically these concentrates on some other different issues of capital structure.

(O’Brien, Klein, and Hilliard 2007), (Kayhan and Titman 2007), (Hovakimian 2005), (Alti 2006), (Elliott, Koeter-Kant, and Warr 2004b), (Huang and Ritter 2004) and (Korajczyk and Levy 2003), generally approves (Baker and Wurgler 2002) findings. But main conflicts are present where this study says that there is a long term impact of market timing on capital structure while other researches discovers that with 2 years era effects of timing behavior disappears.

Implications of Market Timing Theory:

In the efficient market predicted by Modigliani and Millar (1958) the cost of financing do not differ of different types of finance (debt/equity) and therefore, choosing among the two do no hold much difference. However, under the inefficient markets, the cost of finance holds great importance, as it ultimately effects the performance and profitability of a firm.

Baker and Wulgler (2002) investigated that how capital structure is affected by equity market timing. Using all Compustat firms’ basic regression equations has been used to test how capital structure is affected.  The results have showed consistency with the hypothesis of the study that capital structure is largely effected by market timing. Leverage is used as dependent variable, whereas market timing opportunities measured as market-book ratio which are perceived by the managers of firm. These are weighted average past market-book ratios. Results showed that leverage is negatively associated to past market valuations. The results showed that low leveraged are the firms that collect funds when the market valuation of firm is high. In contrast, high leverages are the firms that raise funds during the period of low market valuations. The results also showed that capital structure is largely effected by fluctuations of market valuation, that continue for a decade. The results remained significant whether leverage had been measured with market or book, or whether other control variables (tangibility, profitability and tangibility had been included.

As a result, the author concluded that capital structure is strongly affected by past market values. For example, capital structure of year 2016 will highly depend upon fluctuations in market-book ratio values from 2006 or even before. Therefore, the theory states no optimal structure of capital, rather

Lee and Rahman (1990) empirically investigated the selectivity performance and market timing using a sample of mutual funds. Regression technique has been used to separate ability of stock selection from market timing ability. Using a modified form of security market line, inputs used are individual return as well as market portfolio returns.

Later in the study he argued that good performance on part of manager occurs when he is able to manage the time (market timing) with his ability of forecasting individual assets returns (selection ability).

During selection of selection and timing ability, manager's forecasting ability must be separated in two components:

1) Forecasting of individual stock price movements (Micro forecasting)

2) Forecasting price movements of stock market on a whole (Macro forecasting)

Micro forecasting is called security analysis whereas Macro forecasting is called market timing. Macro forecasting refers to as forecasting future realizations on part of market portfolio. Macro forecaster will capitalize in anticipation he may receive regarding market return behavior in next period. If manager believes that he can earn better than market returns, portfolio risk will be adjusted in expectation of positive market movements. On a successful anticipation a manager could earn much higher return than just average market return. If a manager correctly perceives that high probability has been seen of having high market returns in the upcoming period, manager would be able of earning higher return on portfolio through increasing the risk. On the other hand, he could reduce losses by reducing risk of portfolio. Therefore the manager will switch from higher risky to low risky securities by outguessing correct movement of market.

The results found  a significant relationship of forecasting ability on part of fund manager, stating that funds having no forecasting ability will be considered a passive management and provide just a source of diversification service to shareholder . Kon (1983) and Henriksson (1984) stated negative relationship between market timing and selectivity measures.

 Deesomsak, Paudyal and Pescetto (2004) states that under efficient capital markets predicted by Modigliani and miller (1985), the value of firm is viewed as independent of the capital structure and therefore , debt and equity are considered perfect substitutes over each other, however  if the assumption is relaxed then the choice of determining capital structure becomes an important factor. The study has investigated capital structure determinants in four Asia pacific countries with regard to existing empirical and theoretical literature.

One of the explanatory variable the study has taken is share price performance supported by market timing theory along with other independent variable like tangibility, firm size, profitability and liquidity.  Its expected theoretical relationship is negative and is mostly reported as negative with leverage in the empirical literature.

Literature found to have impact on capital structure of firm. Due to irregular information between outside investors and managers, new shares will be issued at discount. If the equity is issued during the overvaluation of shares, the cost of discount to present shareholders will be very small or even none. Therefore, the preference of firms are equity over debt during the high share price of firms' share. Leverage and share price performance are inversely related, as predicted by theory of market timing (Baker and Wurgler, 2002).

The empirical testing showed that share price performance are found to have significant but negative relationship with leverage in all tested countries. The study proved the negative relationship between leverage and SPP and stated that during higher share prices firms prefer equity over debt. The negative relationship provided support to the existing theories of capital structure.

(Hochberg and Muhlhofer 2011) Basic purpose behind this study was to check how this market timing works for a manager in a real estate business. How they make abnormal profit out of the opportunities provided by the investors.

Two methods by Daniel , wermers and titman (1997), characteristic selectivity and timing to check the behavior of private and public sector in a real estate business and  investor’s overall selection and profitability measures. Both, private and public entities data was collected for the evaluation of investment selection. Private sector was far behind in making successful and profitable investment decisions compared to public sector.

One of the influential aspect was managerial skills, how to tackle the particular situation in a given period. According to finance literature, manager’s role in earning abnormal profits and time to market for investment purpose is still a debatable. 

Different aspect of making investment was observed by the portfolio managers like in real estate business. Author adopted Daniel et al.1997 way of timing and selectivity to time the market while investment by both private and public sector managers’. 

Top portfolio manager in both private and public considered to be as the successful market timers. Though variation in both portfolio managers been found that who run it better. Further to analyze this particular aspect in a manager’s ability to find perfect investment to be invested in, a systematic relationship was the ultimate solution to figure it out.

The most significant side of the study was, how the time to market which was a component can be tackled by the managers in the real estate market. How the managers are making abnormal earning out of it.

(Nasiri and Serkani 2012) In stock market the most essential decision to find the perfect method to select either from borrowing or through offering more shares, in corporate financing. Market time theory was the theory chosen among different theories in order to examine the issues in the financing methods. To check the effect to MTT, regression analysis was done for the selected companies of TSE (Tehran stock exchange).

In this part of survey, we measure the effect of the ratio of market value to book value on the sources of financing firms though increase in equities. Before going further research on the theory, past results by using M/Bs was found as well. Which says firms use the equity more to increase shares. The above opposed to hypothesis from which one of it is confirmed other is still in discussion that is ratio of market to leverage relationship.

Two prospects which the authors did not examined to test the theory was Elliott et al.’s (2007) financing deficit and earning based techniques. Reason behind the rejection of these two points, they were misinterpreting the use of equity valuation. A year later, in 2008 the author examined the MTT refer to capital structure with separate evaluation for both the equity and finance deficit. Which in result helped in preventing the explanation given by M/B ratio analysis. In the same year Mahajan and Tartaroglu studied the major chunk of industrial sector and came up the result that there is negative relationship between leverage and M/B so as for equity issues.

Overall the study focuses on stock exchange whether it has any connectivity with firm financing and other related issues. Based on the hypothesis it explained that there is tendency in firm to increase its shares through equity and same the ration of M/B will be associated with it too to measure the impact. The result show a slightly significant relationship which is yet to be explained further to show the leverage impact.

Poleraiah (2015 ); This theory being reviewed in different market to check the overall off set. In this particular study where some reviews were rejected to a point like Theory of Modigliani and Miller, however Trade off and pecking theory was accepted to review the issues arise in timing the market. Funding is the most important factor firm faces, finance in the longer run or shorter. Firstly it says that capital structure play a vital rule, secondly trade off theory assumes that equity financing can better be controlled and tackle market imperfections i.e. costs like bankruptcy costs and taxes. Lastly Pecking theory says debt financing equity financing is far more than equity financing when it comes to company facings issues in issuing securities. 

We use data from financial statements of Indian companies that were listed on the national Stock Exchange (NSE) during the period 2000 to 2015.

Data from Indian companies were took from 2000 to 2015. Regression analysis will be run to see the changes and effect on overall investment decisions. From IPOs till the company profits. As the study is still under observation to determine the results. Though through sample study negative relationship is expected to be found.

(Clarke, FitzGerald et al. 1989) Most important that been raised in the theory, that market timing can a factor that helped a manager to beat market in earning more money? Even after many studies it stated that timing the market nearly impossible. Which was later discussed by Sharpe’s in an argument that it’s better to invest rather to hold money in hand for abnormal profits. All it depends on manager’s predictability. Later on focused study, rules to be followed, investment can be done following an optimal rule in stocks investment. For that information or related needs to be in hand in an accurate manner. If holding period exceed the time to investment zero profit earning ration is expected. But according the thumb rule, an entity when make an investment, maximum profit is aimed. This will ultimately reduce the transaction cost by not holding money for so long. On doing this investor will have to pay 1% cost, if they have perfect related information about the stock market.

Return on investment will going to increase as per available information. But that does not mean all the investor will get expected returns. Hence, beating market timing does not mean we will get more money.  


In financing corporate, one of the most important issues is to find an appropriate method to make a wise selection between getting loans and increasing the number of shares. Before moving forward, let me give you glimpse of some other theories i.e. Trade-Off Theory, Pecking Order Theory and Market Timing Theory. These were the important concepts to know, as (Huang and Ritter (2005), Jahanzeb 2013);Poleraiah (2015 );Luigi and Sorin (2009) and many other authors compare this theory with Market timing theory.

Trade-Off Theory:

Trade-off theory comprises on how much debt finance and how much equity finance should firms used by balancing the costs and benefits. (Jahanzeb 2013) discussed the tax shield provided by the debt financing i.e.; tax shields to the earnings. But at the same side (Henriksson and Merton 1981) compare the costs and the benefits of debt and potentially discussed about bankruptcy costs and agency conflicts between bond holders and shareholders. Theory suggested that firms should issue equity when their leverage is above the desired target and issue debt when leverage is below the target, or issue debt and equity respectively to stay close to the targeted leverage.

Pecking Order Theory:

(Huang and Ritter 2005) explained that firms had postulate order of financing.  Most of the firms prefer internally generated funds, and raise external funds only if internal funds are insufficient. If external funds are required, they prefer straight debt, then convertible debt, and finally external equity. The main difference between the pecking order theory and the market timing theory is the semi-strong form of market efficiency assumed.

Comparison with Market Timing Theory:

Market timing theory is all about window of opportunity. As it is discussed previously in detail, states that firms prefer external equity when the cost of equity is low, and prefer debt otherwise.

(Huang and Ritter 2005) compares these theories and concluded that Market timing theory is a challenge for both of the other theories, because Market timing theory provides an adequate explanation on time-variation but others were fail to do. So, he supported Market timing theory but also concluded that security issue or capital structure decisions were not durable, theory still need more work in this context.

(Jahanzeb 2013) refers that market timing theory evidently proved, manger wait for the stocks position to get better (increase in prices of stocks) before issuing new stocks. As other theories explained the capital structure extensively, but Market timing does required to incorporate dynamic models which will furnish assumed results and theoretical results in order to understand the complexity of these theories in a better way.

(Virk, Ahmed et al. 2014) discussed the financing decisions in Pakistan regard to market timing theory. In his studies, he doesn’t support market timing theory. He suggested that firms in Pakistan shouldn’t issue equity during the high variations. It may be due to underdeveloped equity and debt markets for Pakistan and also because Pakistan is facing the issue that managers are using the firms excess resources which led firms to use more debt, or this might only be due to the fact that mostly firms use short term financing in the case of Pakistan.

Market timing theory still needs to explore that, why some firms tends to issue equity while other issue debt at the same time. Nobody has explained this problem within a model of market timing. Therefore market timing is seen as incomplete theory.


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