Pockets of Predictability
80 Pages Posted: 29 Mar 2018 Last revised: 19 Apr 2019
Date Written: April 9, 2019
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: Suggested Citation