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

See all articles by Giulia Dal Pra

Giulia Dal Pra

Independent

Massimo Guidolin

Bocconi University, Dept. of Finance; Bocconi University - CAREFIN - Centre for Applied Research in Finance

Manuela Pedio

University of Bristol; Bocconi University - CAREFIN - Centre for Applied Research in Finance

Fabiola Vasile

Euromobiliare Asset Management SGR

Date Written: December 1, 2016

Abstract

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

Suggested Citation

Dal Pra, Giulia and Guidolin, Massimo and Pedio, Manuela and Vasile, Fabiola, Do Regimes in Excess Stock Return Predictability Create Economic Value? An Out-of-Sample Portfolio Analysis (December 1, 2016). BAFFI CAREFIN Centre Research Paper No. 2016-37, Available at SSRN: https://ssrn.com/abstract=2852301 or http://dx.doi.org/10.2139/ssrn.2852301

Giulia Dal Pra

Independent ( email )

Massimo Guidolin (Contact Author)

Bocconi University, Dept. of Finance ( email )

Via Roentgen, 1
2nd floor
Milan, MI 20136
Italy

Bocconi University - CAREFIN - Centre for Applied Research in Finance

Via Sarfatti 25
Milan, 20136
Italy

Manuela Pedio

University of Bristol ( email )

University of Bristol,
Senate House, Tyndall Avenue
Bristol, Avon BS8 ITH
United Kingdom

Bocconi University - CAREFIN - Centre for Applied Research in Finance ( email )

Via Sarfatti, 25
Milan, 20136
Italy

Fabiola Vasile

Euromobiliare Asset Management SGR ( email )

Italy

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