Time-varying equity premium forecasts based on industry indexes

Various studies report that the ability of industry indexes to predict the broad market disappeared during the most recent years. I revisit this theme using more flexible switching models and imposing economically motivated constraints on the predictions. My results show that traditional constant c...

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Main Author: Nuno Silva
Format: Article
Language:English
Published: Tuwhera Open Access Publisher 2020-12-01
Series:Applied Finance Letters
Online Access:https://ojs.aut.ac.nz/applied-finance-letters/article/view/298
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spelling doaj-d587f0752f4f4d8698714b4f14a4824c2021-02-02T21:08:52ZengTuwhera Open Access PublisherApplied Finance Letters2253-57992253-58022020-12-01910.24135/afl.v9i.298Time-varying equity premium forecasts based on industry indexesNuno Silva0University of Coimbra Various studies report that the ability of industry indexes to predict the broad market disappeared during the most recent years. I revisit this theme using more flexible switching models and imposing economically motivated constraints on the predictions. My results show that traditional constant coefficients linear models are unable to forecast the stock market over the period considered, but restricting the equity premium to be non-negative, five industries predict the market. I also show that the Markov-switching models exhibit a dismal performance, which is even worse than the ones from the constant coefficients model. Finally, I test a model with two regimes- recession and expansion- which are identified in real-time through the Arouba-Diebold-Scotti Business Conditions Index. Using this model, I find that 8 out of 33 industries can successfully forecast the market. Furthermore, a mean-variance investor who bases his decisions on it obtains sizeable utility gains, relative to another investor who uses, exclusively, the historical returns. https://ojs.aut.ac.nz/applied-finance-letters/article/view/298
collection DOAJ
language English
format Article
sources DOAJ
author Nuno Silva
spellingShingle Nuno Silva
Time-varying equity premium forecasts based on industry indexes
Applied Finance Letters
author_facet Nuno Silva
author_sort Nuno Silva
title Time-varying equity premium forecasts based on industry indexes
title_short Time-varying equity premium forecasts based on industry indexes
title_full Time-varying equity premium forecasts based on industry indexes
title_fullStr Time-varying equity premium forecasts based on industry indexes
title_full_unstemmed Time-varying equity premium forecasts based on industry indexes
title_sort time-varying equity premium forecasts based on industry indexes
publisher Tuwhera Open Access Publisher
series Applied Finance Letters
issn 2253-5799
2253-5802
publishDate 2020-12-01
description Various studies report that the ability of industry indexes to predict the broad market disappeared during the most recent years. I revisit this theme using more flexible switching models and imposing economically motivated constraints on the predictions. My results show that traditional constant coefficients linear models are unable to forecast the stock market over the period considered, but restricting the equity premium to be non-negative, five industries predict the market. I also show that the Markov-switching models exhibit a dismal performance, which is even worse than the ones from the constant coefficients model. Finally, I test a model with two regimes- recession and expansion- which are identified in real-time through the Arouba-Diebold-Scotti Business Conditions Index. Using this model, I find that 8 out of 33 industries can successfully forecast the market. Furthermore, a mean-variance investor who bases his decisions on it obtains sizeable utility gains, relative to another investor who uses, exclusively, the historical returns.
url https://ojs.aut.ac.nz/applied-finance-letters/article/view/298
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