Understanding and Forecasting Stock Price Changes

FEDEA Working Paper No. 2006-03

17 Pages Posted: 14 Feb 2006  

Pedro N. Rodriguez

Complutense University of Madrid - Facultad de Ciencias Económicas y Empresariales - Departamento de Estadística e Investigación Operativa II

Simon Sosvilla-Rivero

Complutense Institute for International Studies

Date Written: January 2006

Abstract

Previous empirical studies have shown that predictive regressions in which model uncertainty is assessed and propagated generate desirable properties when predicting out-of-sample. However, it is still not clear (a) what the important conditioning variables for predicting stock returns out-of-sample are, and (b) how composite weighted ensembles outperform model selection criteria. By comparing the unconditional accuracy of prediction regressions to the conditional accuracy (conditioned on specific explanatory variables masked), we find that cross-sectional premium and term spread are robust predictors of future stock returns. Additionally, using the bias-variance decomposition for the 0/1 loss function, the analysis shows that lower bias, and not lower variance, is the fundamental difference between composite weighted ensembles and model selection criteria. This difference, nevertheless, does not necessarily imply that model averaging techniques improve our ability to describe monthly up-and-down movements' behavior in stock markets.

Keywords: Stock return predictability, Model averaging, Bias-variance decomposition

JEL Classification: G11, G15, C11

Suggested Citation

Rodriguez, Pedro N. and Sosvilla-Rivero, Simon, Understanding and Forecasting Stock Price Changes (January 2006). FEDEA Working Paper No. 2006-03. Available at SSRN: https://ssrn.com/abstract=882028 or http://dx.doi.org/10.2139/ssrn.882028

Pedro N. Rodriguez

Complutense University of Madrid - Facultad de Ciencias Económicas y Empresariales - Departamento de Estadística e Investigación Operativa II ( email )

Carretera de Humera s/n
Madrid 28223, Madrid 28223
Spain

HOME PAGE: http://www.pnrodriguez.com

Simon Sosvilla-Rivero (Contact Author)

Complutense Institute for International Studies ( email )

Carretera de Humera s/n
Madrid, Madrid 28223
Spain
+34913932626 (Phone)

HOME PAGE: http://www.ucm.es/info/ecocuan/ssr/

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