Forecasting Stock Market Returns: The Sum of the Parts is More than the Whole
57 Pages Posted: 19 Aug 2010
Date Written: August 18, 2010
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.
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