Pockets of Predictability

72 Pages Posted: 23 Apr 2018

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 2018

Abstract

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 empirically using a flexible non-parametric approach and explore possible explanations of this finding, including time-varying risk premia. We find that short-lived predictability pockets are inconsistent with a broad class of affine asset pricing models. Conversely, pockets of return predictability are more in line with a model with investors' incomplete learning about a highly persistent growth component in the underlying cash flow process which undergoes occasional regime shifts.

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

Suggested Citation

Farmer, Leland and Schmidt, Lawrence and Timmermann, Allan, Pockets of Predictability (April 2018). CEPR Discussion Paper No. DP12885. Available at SSRN: https://ssrn.com/abstract=3167250

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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