Macro Trends and Factor Timing

We find that the value of well-known systematic (characteristics-based) risk factors, like SMB and HML, is anchored to macroeconomic trends related to inflation and real economic activity. Exploiting the cointegration logic, when the price of a factor is greater than the long-term value implied by the macro trends, expected returns should be lower over the next period. We provide strong supporting evidence for this intuition: deviations of factor prices from their value implied by macroeconomic conditions predict factor returns both in- and out-of-sample, translating into significant economic gains from the perspective of a mean-variance investor. Finally, our approach leads to an estimated SDF that displays sizable variation over time when benchmarked against standard long-run risk or habit models.