Stock Return Predictability: comparing Macro- and Micro-Approaches

Abstract

Economic theory identifies two potential sources of return predictability: time variation in expected returns (beta-predictability) or market inefficiencies (alpha-predictability). For the latter, Samuelson argued that macro-returns exhibit more inefficiencies than micro-returns, as individual stories are averaged out, leaving only harder-to-eliminate macro-mispricing at the index-level. To evaluate this claim, we compare macro- and micro-predictability on US data to gauge if the former turns out higher than the latter. Additionally, we extend over time the methodology of Rapach et al. (2011) to disentangle the two sources of predictability. We first find that Samuelson's view appears incorrect, as micro-predictability is not structurally lower than macro-predictability. Second, we find that our estimated alpha- and betapredictability indices are coherent with their corresponding theoretical implications (the alpha-predictability being high in times of bullish markets, and the beta-predictability in recessive periods), thus suggesting that the two mechanisms are at play in our dataset.

Keywords: Out-of-Sample Return Predictability; Efficient Market Hypothesis; Conditional Beta Pricing Model; Alpha Predictability

JEL Classification: C22, C53, G12, G14, G17