Does the CAPM Predict Returns?

Abstract

We provide empirical evidence that asset returns can be predicted using the CAPM. When predicting next month's returns, the CAPM yields an out-of-sample R2 of about 4% across portfolios and of about 2.7% across S\&P 500 stocks. That is, the predictive power of the market return predictor transmits to the product of the asset beta and the expected market return. As a consequence, trading strategies exploiting the predictive power of the CAPM have Sharpe ratios up to 125% larger than those of the corresponding buy-and-hold strategies. Furthermore, the average return of these trading strategies increases with their systematic risk (beta).

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

JEL Classification: D53, G11, G12