Does the CAPM Predict Returns?

Abstract

We provide strong empirical evidence that asset returns can be predicted using the dynamic CAPM. Indeed, the predictive power of the market return predictor transmits to the product of the asset's conditional beta and the market expected return. The dynamic CAPM yields a monthly out-of-sample R2 of about 4% across all test assets, which is of the same order of magnitude as the out-of-sample R2 obtained by predicting market returns using the market return predictor. Strategies exploiting the predictive power of the dynamic CAPM have Sharpe ratios up to 100% larger than those of the corresponding buy-and-hold strategies.

Keywords: capital asset pricing model, predictability, cross-section of stock returns

JEL Classification: D53, G11, G12