The optimal factor timing portfolio is equivalent to the stochastic discount factor. We propose and implement a method to characterize both empirically. Our approach imposes restrictions on the dynamics of expected returns which lead to an economically plausible SDF. Market-neutral equity factors are strongly and robustly predictable. Exploiting this predictability leads to substantial improvement in portfolio performance relative to static factor investing. The variance of the corresponding SDF is larger, more variable over time, and exhibits different cyclical behavior than estimates ignoring this fact. These results pose new challenges for theories that aim to match the cross-section of stock returns.
We thank John Campbell, Mikhail Chernov, John Cochrane, Julien Cujean, Robert Dittmar, Kenneth French, Stefano Giglio, Bryan Kelly, Ralph Koijen, Hugues Langlois, Lars Lochstoer, Mark Loewenstein, Tyler Muir, Stefan Nagel, Nikolai Roussanov, Avanidhar Subrahmanyan, Michael Weber and seminar participants at AFA, Chicago, FIRS, LSE, Maryland, Michigan, University of Washington, and NBER for helpful comments and suggestions. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.