Pockets of Predictability

80 Pages Posted: 29 Mar 2018 Last revised: 19 Apr 2019

See all articles by Leland Farmer

Leland Farmer

University of Virginia

Lawrence Schmidt

MIT Sloan School of Management

Allan Timmermann

UCSD ; Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 2 versions of this paper

Date Written: April 9, 2019

Abstract

For many benchmark predictor variables, short-horizon return predictability in the U.S. stock market is local in time as short periods with significant predictability (‘pockets’) are interspersed with long periods with little or no evidence of return predictability. We document this result empirically using a flexible time-varying parameter model which estimates predictive coefficients as a nonparametric function of time and explore possible explanations of this finding, including time-varying risk-premia for which we only find limited support. Conversely, pockets of return predictability are consistent with a model of incomplete learning in which boundedly rational investors use macroeconomic proxies to track movements in a highly persistent growth component in the underlying cash flow process and fail to incorporate effects of future revisions in beliefs into current prices.

Keywords: Predictability of stock returns; incomplete learning; Markov switching predictive systems; cash flows; affine asset pricing models

JEL Classification: G12, C58, C14

Suggested Citation

Farmer, Leland and Schmidt, Lawrence and Timmermann, Allan, Pockets of Predictability (April 9, 2019). Available at SSRN: https://ssrn.com/abstract=3152386 or http://dx.doi.org/10.2139/ssrn.3152386

Leland Farmer (Contact Author)

University of Virginia ( email )

237 Monroe Hall
P.O. Box 400182
Charlottesville, VA 22904-418
United States

Lawrence Schmidt

MIT Sloan School of Management ( email )

77 Massachusetts Avenue
Cambridge, MA 02139-4307
United States

HOME PAGE: http://https://sites.google.com/site/lawrencedwschmidt/home

Allan Timmermann

UCSD ( email )

9500 Gilman Drive
La Jolla, CA 92093-0553
United States
858-534-0894 (Phone)

HOME PAGE: http://rady.ucsd.edu/people/faculty/timmermann/

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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