Does the CAPM Predict Returns?

Abstract

We provide strong empirical evidence that asset excess returns can be predicted using the dynamic CAPM. When predicting next month excess returns, the dynamic CAPM yields an out-of-sample R2 of about 4% across all portfolios and of about 2.7% across all S&P 500 stocks. That is, the predictive power of the market return predictor transmits to the product of the asset's dynamic beta and the dynamic risk premium of the market. As a consequence, 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