The Scale of Predictability
67 Pages Posted: 5 Dec 2012 Last revised: 17 Jul 2018
Date Written: June 25, 2018
We introduce a new stylized fact: the hump-shaped behavior of slopes and coefficients of determination as a function of the aggregation horizon when running (forward/backward) predictive regressions of future excess market returns onto past economic uncertainty (as proxied by market variance, consumption variance, or economic policy uncertainty). To justify this finding formally, we propose a novel modeling framework in which predictability is specified as a property of low-frequency components of both excess market returns and economic uncertainty. We dub this property scale-specific predictability. We show that classical predictive systems imply restricted forms of scale-specific predictability. We conclude that for certain predictors, like economic uncertainty, the restrictions imposed by classical predictive systems may be excessively strong.
Keywords: predictability, frequency, aggregation, risk-return trade-off
JEL Classification: C51, E32, G12, G17
Suggested Citation: Suggested Citation