Forecasting Stock Market Returns: The Sum of the Parts is More than the Whole
Miguel A. Ferreira
Nova School of Business and Economics; European Corporate Governance Institute (ECGI)
New University of Lisbon - Nova School of Business and Economics; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)
July 14, 2010
AFA 2010 Atlanta Meetings Paper
We propose forecasting separately the three components of stock market returns: the dividend-price ratio, earnings growth, and price-earnings ratio growth --- the sum-of-the-parts (SOP) method. Our method exploits the different time-series persistence of the components and obtains out-of-sample R-squares (compared to the historical mean) of more than 1.3% with monthly data and 13.4% with yearly data. This compares with typically negative R-squares obtained in a similar experiment with predictive regressions. The performance of the SOP method comes mainly from the dividend-price ratio and earnings growth components and the robustness of the method is due to its low estimation error. An investor who timed the market using our method would have had a Sharpe ratio gain of 0.3.
Number of Pages in PDF File: 57
Keywords: Equity premium, forecasting, stock market, predictive regression
JEL Classification: G1
Date posted: March 22, 2009 ; Last revised: July 25, 2010
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