Pockets of Predictability
113 Pages Posted: 29 Mar 2018 Last revised: 14 Feb 2022
Date Written: January 25, 2022
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 sticky expectations model in which investors only slowly update their beliefs about a persistent component in the cash flow process.
Keywords: Out-of-sample return predictability; time-varying expected returns; sticky expectations; affine asset pricing models
JEL Classification: G12, C58, C14
Suggested Citation: Suggested Citation