Forecast and Market Timing Power of the FED Model and the Role of Inflation
34 Pages Posted: 6 Jun 2015
Date Written: June 4, 2015
We considers two key questions regarding predictive power of the FED model for stock returns. First, utilising a rolling regression approach designed to mimic real time investors, we provide evidence that the FED model, together with interest rates and the dividend-price ratio, can forecast stock returns. Both statistical and economic based measures provide evidence in favour of such forecasting ability. Notably, we provide evidence of significant market timing ability. Second, we examine the role of inflation in this predictive framework. Primarily using threshold regressions, we present results that demonstrate the strength of the positive relationship between the equity and bond yield that underlies the FED model strengthens with higher inflation. However, the predictive power weakens, as higher inflation can mask the signal emanating from the model. These results suggest an explanation for the time-varying and often inconclusive nature of the FED models forecast power for stock returns.
Keywords: Stock Returns, FED Model, Rolling Regression, Forecasting, Market Timing, Inflation
JEL Classification: C22, G12
Suggested Citation: Suggested Citation