Do Regimes in Excess Stock Return Predictability Create Economic Value? An Out-of-Sample Portfolio Analysis
39 Pages Posted: 15 Oct 2016 Last revised: 18 Dec 2020
Date Written: December 1, 2016
We analyze the recursive, out-of-sample performance of asset allocation decisions based on financial ratio-predictability under single-state linear and regime-switching models. We adopt both a statistical perspective to analyze whether models based on the dividend-price, earning-price, and book-to-market ratios can forecast excess equity returns, and an economic approach that turns predictions into portfolio strategies. The strategies consist of a portfolio switching approach, a mean-variance framework, and a long-run dynamic model. We report an interesting disconnect between a statistical perspective, whereby the ratios yield a modest forecasting power, and a portfolio approach, by which a moderate predictability is occasionally sufficient to yield significant portfolio outperformance, especially before transaction costs and when regimes are taken into account. However, also when regimes are considered, predictability gives high payoffs only to long-horizon, highly risk-averse asset managers. Moreover, different strategies deliver different performance rankings across predictors. Finally, we find evidence inconsistent with the notion that increasing sophistication in the way portfolio decisions are modeled, delivers a superior performance.
Keywords: predictability, Markov switching, economic value, optimal portfolio choice
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