Forecasting Stock Returns

78 Pages Posted: 12 Apr 2023

See all articles by David Rapach

David Rapach

Research Department, Federal Reserve Bank of Atlanta; Washington University in St. Louis

Guofu Zhou

Washington University in St. Louis - John M. Olin Business School

Date Written: March 29, 2023

Abstract

We survey the literature on stock return forecasting, highlighting the challenges faced by forecasters as well as strategies for improving return forecasts. We focus on U.S. equity premium forecastability and illustrate key issues via an empirical application based on updated data. Some studies argue that, despite extensive in-sample evidence of equity premium predictability, popular predictors from the literature fail to outperform the simple historical average benchmark forecast in out-of-sample tests. Recent studies, however, provide improved forecasting strategies that deliver statistically and economically significant out-of-sample gains relative to the historical average benchmark. These strategies—including economically motivated model restrictions, forecast combination, diffusion indices, and regime shifts—improve forecasting performance by addressing the substantial model uncertainty and parameter instability surrounding the data-generating process for stock returns. In addition to the U.S. equity premium, we succinctly survey out-of-sample evidence supporting U.S. cross-sectional and international stock return forecastability. The significant evidence of stock return forecastability worldwide has important implications for the development of both asset pricing models and investment management strategies.

Keywords: Equity premium; Economic variables; Technical indicators; Forecast combination; Diffusion index; Regime shifts; Asset pricing model; Asset allocation; Business cycle

JEL Classification: C22, C38, C53, C58, E32, G11, G12, G14, G17

Suggested Citation

Rapach, David and Zhou, Guofu, Forecasting Stock Returns (March 29, 2023). Available at SSRN: https://ssrn.com/abstract=4403635 or http://dx.doi.org/10.2139/ssrn.4403635

David Rapach

Research Department, Federal Reserve Bank of Atlanta ( email )

1000 Peachtree Street N.E.
Atlanta, GA 30309-4470
United States

Washington University in St. Louis ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States

HOME PAGE: http://https://sites.google.com/slu.edu/daverapach

Guofu Zhou (Contact Author)

Washington University in St. Louis - John M. Olin Business School ( email )

Washington University
Campus Box 1133
St. Louis, MO 63130-4899
United States
314-935-6384 (Phone)
314-658-6359 (Fax)

HOME PAGE: http://apps.olin.wustl.edu/faculty/zhou/

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