Market timing hypothesis
Encyclopedia
The market timing hypothesis is a theory of how firms and corporation
s in the economy
decide whether to finance their investment with equity
or with debt
instruments. It is one of many such corporate finance
theories, and is often contrasted with the pecking order theory
and the trade-off theory, for example. The idea that firms pay attention to market conditions in an attempt to time the market is a very old hypothesis.
Baker and Wurgler (2002), claim that market timing is the first order determinant of a corporation's capital structure
use of debt and equity. In other words, firms do not generally care whether they finance with debt or equity, they just choose the form of financing which, at that point in time, seems to be more valued by financial markets.
Market timing is sometimes classified as part of the behavioral finance
literature, because it does not explain why there would be any asset mis-pricing, or why firms would be better able to tell when there was mis-pricing than financial markets. Rather it just assumes these mis-pricing exists, and describes the behavior of firms under the even stronger assumption that firms can detect this mis-pricing better than markets can. However, any theory with time varying costs and benefits is likely to generate time varying corporate issuing decisions. This is true whether decision makers are behavioral or rational.
The empirical evidence for this hypothesis
is at best, mixed. Baker and Wurgler themselves show that an index of financing that reflects how much of the financing was done during hot equity periods
and how much during hot debt periods
is a good indicator of firm leverage
over long periods subsequently. Alti studied issuance events. He found that the effect of market timing disappears after only two years.
Direct evidence that firms are generally able to beat the market is not supportive. Even for the most active issuers it is hard to reject the hypothesis that the timing of the issuing decisions is random.
Beyond such academic studies, a complete market timing theory ought to explain why at the same moment in time some firms issue debt while other firms issue equity. As yet nobody has tried to explain this basic problem within a market timing model. The typical version of the market timing hypothesis is thus somewhat incomplete as a matter of theory.
Corporation
A corporation is created under the laws of a state as a separate legal entity that has privileges and liabilities that are distinct from those of its members. There are many different forms of corporations, most of which are used to conduct business. Early corporations were established by charter...
s in the economy
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...
decide whether to finance their investment with equity
Ownership equity
In accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If liability exceeds assets, negative equity exists...
or with debt
Debt
A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...
instruments. It is one of many such corporate finance
Corporate finance
Corporate finance is the area of finance dealing with monetary decisions that business enterprises make and the tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize shareholder value while managing the firm's financial risks...
theories, and is often contrasted with the pecking order theory
Pecking Order Theory
In the theory of firm's capital structure and financing decisions, the Pecking Order Theory or Pecking Order Model was first suggested by Donaldson in 1961 and it was modified by Stewart C. Myers and Nicolas Majluf in 1984...
and the trade-off theory, for example. The idea that firms pay attention to market conditions in an attempt to time the market is a very old hypothesis.
Baker and Wurgler (2002), claim that market timing is the first order determinant of a corporation's capital structure
Capital structure
In finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equity and $80...
use of debt and equity. In other words, firms do not generally care whether they finance with debt or equity, they just choose the form of financing which, at that point in time, seems to be more valued by financial markets.
Market timing is sometimes classified as part of the behavioral finance
Behavioral finance
Behavioral economics and its related area of study, behavioral finance, use social, cognitive and emotional factors in understanding the economic decisions of individuals and institutions performing economic functions, including consumers, borrowers and investors, and their effects on market...
literature, because it does not explain why there would be any asset mis-pricing, or why firms would be better able to tell when there was mis-pricing than financial markets. Rather it just assumes these mis-pricing exists, and describes the behavior of firms under the even stronger assumption that firms can detect this mis-pricing better than markets can. However, any theory with time varying costs and benefits is likely to generate time varying corporate issuing decisions. This is true whether decision makers are behavioral or rational.
The empirical evidence for this hypothesis
Hypothesis
A hypothesis is a proposed explanation for a phenomenon. The term derives from the Greek, ὑποτιθέναι – hypotithenai meaning "to put under" or "to suppose". For a hypothesis to be put forward as a scientific hypothesis, the scientific method requires that one can test it...
is at best, mixed. Baker and Wurgler themselves show that an index of financing that reflects how much of the financing was done during hot equity periods
Hot equity periods
In the study of financial markets Hot equity periods or Hot Issue Periods are periods of time in which many firms perform initial public offering of their equity. Firms in modern economies often finance themselves by the issuance in public markets of shares, also called equity...
and how much during hot debt periods
Hot debt periods
In the theory of corporate finance, the name of Hot debt period is given to periods of time when new debt issues by corporations are very common, and generally coincide with periods in which the interest rate is low, and the risk premium on corporate debt issues is low, giving these new bonds high...
is a good indicator of firm leverage
Leverage (finance)
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
over long periods subsequently. Alti studied issuance events. He found that the effect of market timing disappears after only two years.
Direct evidence that firms are generally able to beat the market is not supportive. Even for the most active issuers it is hard to reject the hypothesis that the timing of the issuing decisions is random.
Beyond such academic studies, a complete market timing theory ought to explain why at the same moment in time some firms issue debt while other firms issue equity. As yet nobody has tried to explain this basic problem within a market timing model. The typical version of the market timing hypothesis is thus somewhat incomplete as a matter of theory.
See also
- Corporate financeCorporate financeCorporate finance is the area of finance dealing with monetary decisions that business enterprises make and the tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize shareholder value while managing the firm's financial risks...
- Pecking order theoryPecking Order TheoryIn the theory of firm's capital structure and financing decisions, the Pecking Order Theory or Pecking Order Model was first suggested by Donaldson in 1961 and it was modified by Stewart C. Myers and Nicolas Majluf in 1984...
- Capital structureCapital structureIn finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equity and $80...
- Trade-off theory