Forecasting Stock Returns Under Economic Constraints

Abstract

We propose a new approach to imposing economic constraints on forecasts of the equity premium. Economic constraints are used to modify the posterior distribution of the parameters of the predictive return regression in a way that better allows the model to learn from the data. We consider two types of constraints: Non-negative equity premia and bounds on the conditional Sharpe ratio, the latter of which incorporates time-varying volatility in the predictive regression framework. Empirically, we …find that economic constraints systematically reduce uncertainty about model parameters and improve both statistical and economic measures of out-of-sample forecast performance. The Sharpe ratio constraint, in particular, results in considerable economic gains.

Keywords: Economic constraints, Sharpe ratio, Equity premium predictions, Bayesian analysis

JEL Classification: C11, C22, G11, G12