Out-of-Sample Equity Premium Prediction: Combination Forecasts and Links to the Real Economy

Posted: 1 Feb 2010

See all articles by David E. Rapach

David E. Rapach

Seattle University, Albers School of Business and Economics

Jack Strauss

University of Denver - Daniels College of Business

Guofu Zhou

Washington University in St. Louis - John M. Olin Business School; China Academy of Financial Research (CAFR)

Date Written: August 2009

Abstract

Welch and Goyal (2008) find that numerous economic variables with in-sample predictive ability for the equity premium fail to deliver consistent out-of-sample forecasting gains relative to the historical average. Arguing that model uncertainty and instability seriously impair the forecasting ability of individual predictive regression models, we recommend combining individual forecasts. Combining delivers statistically and economically significant out-of-sample gains relative to the historical average consistently over time. We provide two empirical explanations for the benefits of forecast combination: (i) combining forecasts incorporates information from numerous economic variables while substantially reducing forecast volatility; (ii) combination forecasts are linked to the real economy.

Keywords: C22, C53, G11, G12

Suggested Citation

Rapach, David E. and Strauss, Jack and Zhou, Guofu, Out-of-Sample Equity Premium Prediction: Combination Forecasts and Links to the Real Economy (August 2009). Review of Financial Studies, Vol. 23, Issue 2, pp. 821-862, 2009, Available at SSRN: https://ssrn.com/abstract=1544161 or http://dx.doi.org/hhp063

David E. Rapach (Contact Author)

Seattle University, Albers School of Business and Economics ( email )

900 Broadway
Seattle, WA 98122
United States
206-296-5705 (Phone)

Jack Strauss

University of Denver - Daniels College of Business ( email )

2101 S. University Blvd.
Denver, CO 80208
United States

Guofu Zhou

Washington University in St. Louis - John M. Olin Business School ( email )

Washington University
Campus Box 1133
St. Louis, MO 63130-4899
United States
314-935-6384 (Phone)
314-658-6359 (Fax)

HOME PAGE: http://apps.olin.wustl.edu/faculty/zhou/

China Academy of Financial Research (CAFR)

Shanghai Advanced Institute of Finance
Shanghai P.R.China, 200030
China

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