Understanding Stock Return Predictability

FRB of St. Louis Working Paper No. 2006-019B

60 Pages Posted: 15 Apr 2006

See all articles by Hui Guo

Hui Guo

University of Cincinnati - Department of Finance - Real Estate

Robert Savickas

George Washington University - School of Business - Department of Finance

Date Written: October 2006

Abstract

Over the period 1927:Q1 to 2005:Q4, the average CAPM-based idiosyncratic variance (IV) and stock market variance jointly forecast stock market returns. This result holds up quite well in a number of robustness checks, and we show that the predictive power of the average IV might come from its close relation with systematic risk omitted from CAPM. First, high lagged returns on high IV stocks predict low future returns on the market as a whole. Second, returns on a hedging portfolio that is long in stocks with low IV and short in stocks with high IV perform as well as the value premium in explaining the cross-section of stock returns. Third, realized variance of the hedging portfolio or of the value premium is closely correlated with the average IV, and these variables have similar predictive power for stock returns.

Keywords: Stock Return Predictability, Average Idiosyncratic Variance, Stock Market Variance, Discount-Rate Shock, Cash-Flow Shock, CAPM, and ICAPM

JEL Classification: G1

Suggested Citation

Guo, Hui and Savickas, Robert, Understanding Stock Return Predictability (October 2006). FRB of St. Louis Working Paper No. 2006-019B. Available at SSRN: https://ssrn.com/abstract=893798 or http://dx.doi.org/10.2139/ssrn.893798

Hui Guo (Contact Author)

University of Cincinnati - Department of Finance - Real Estate ( email )

College of Business
418 Carl H. Lindner Hall
Cincinnati, OH 45221
United States
513.556.7077 (Phone)
513.556.0979 (Fax)

HOME PAGE: http://homepages.uc.edu/~guohu/

Robert Savickas

George Washington University - School of Business - Department of Finance ( email )

Funger Hall, Suite 501R
2201 G Street, N.W.
Washington, DC 20052
United States
202-994-8936 (Phone)
202-994-5014 (Fax)

HOME PAGE: http://savickas.net/

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