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Forecasting Stock Market Returns by Summing the Frequency-Decomposed Parts

49 Pages Posted: 2 Dec 2016 Last revised: 23 Nov 2017

Gonçalo Faria

Catholic University of Portugal (UCP) - School of Economics and Management and CEGE

Fabio Verona

Bank of Finland - Research

Date Written: November 28, 2016

Abstract

We generalize the Ferreira and Santa-Clara (2011) sum-of-the-parts method for forecasting stock market returns. Rather than summing the parts of stock returns, we suggest summing some of the frequency-decomposed parts. The proposed method signi cantly improves upon the original sum-of-the-parts and delivers statistically and economically gains over historical mean forecasts, with monthly out-of-sample R2 of 2.60% and annual utility gains of 558 basis points. The strong performance of this method comes from its ability to isolate the frequencies of the parts with the highest predictive power, and from the fact that the selected frequency-decomposed parts carry complementary information that captures di erent frequencies of stock market returns.

Keywords: predictability, stock returns, equity premium, asset allocation, frequency domain, wavelets

JEL Classification: G11, G12, G14, G17

Suggested Citation

Faria, Gonçalo and Verona, Fabio, Forecasting Stock Market Returns by Summing the Frequency-Decomposed Parts (November 28, 2016). Bank of Finland Research Discussion Paper No. 29/2016. Available at SSRN: https://ssrn.com/abstract=2878752

Gonçalo Faria (Contact Author)

Catholic University of Portugal (UCP) - School of Economics and Management and CEGE ( email )

Universidade Católica Portuguesa
Rua Diogo Botelho 1327
Porto, 4169-005
Portugal

Fabio Verona

Bank of Finland - Research ( email )

P.O. Box 160
FIN-00101 Helsinki
Finland

HOME PAGE: http://bofcris.solenovo.fi/crisyp/disp/_/en/cr_redir_all/fet/fet/sea?direction=3&id=3827426

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