By Tommi Johnsen, PhD|Published On: December 26th, 2023|Categories: Empirical Methods, Predicting Market Returns, Research Insights, Basilico and Johnsen, Academic Research Insight|
The question of whether stock returns are predictable is of long-standing interest to both academics and investment practitioners. Commonly accepted investment strategies, for example, will behave quite differently in the presence of stock return predictability.The research literature is unclear on the answer and suggests that return predictability, if it exists, will be difficult to exploit on an out-of-sample basis under any scenario. Other studies find that return predictability is instead, highly unstable and time-varying.However, academic tests are hampered by estimation methods that are linear and produce a constant coefficient using data covering long time horizons.Linear regressions of this sort produce an “average” analysis.That is, they are only able to answer the question of whether returns are predictable on average.
Pockets of Predictability
- Leland E. Farmer, Lawrence Schmidt, and Allan Timmerman
- Journal of Finance
- A version of this paper can be foundhere
- Want to read our summaries of academic finance papers? Check out our Academic Research Insight category.
What are the research questions?
- Are stock returns predictable?
What are the Academic Insights?
- YES, but they occur in pockets across time. For the most part, the authors report that stock returns are unpredictable. However, there do exist points of pockets in time when returns can be predicted. Fortunately, the predictability that does occur is found to be exploitable and economically significant. The authors also develop a theoretical model of valuation that uses expectations about growth in future cash flows. In the model, a gap is allowed to form between expectations and forecasts of actual cash flows. Those gaps give rise to pockets of predictability confined to short-time horizons. The model uses dividend to price, the risk-free rate, and actual volatility to demonstrate how this happens. See Table II for a statistical description of pockets that demonstrate return predictability.
Why does it matter?
This research presented here moves the narrative on return predictability by using an estimation method capable of identifying shifts in return predictability. Using regressions with time-varying features allows the estimated coefficient to follow the predictability as a function of calendar time.
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged and do not reflect management or trading fees, and one cannot invest directly in an index.
Abstract
For many benchmark predictor variables, short-horizon return predictability in the U.S. stock market is local in time as short periods with significant predictability (“pockets”) are interspersed with long periods with no predictability. We document this result empirically using a flexible time-varying parameter model that estimates predictive coefficients as a nonparametric function of time and explore possible explanations of this finding, including time-varying risk premia for which we find limited support. Conversely, pockets of return predictability are consistent with a sticky expectations model in which investors slowly update their beliefs about a persistent component in the cash flow process.
About the Author: Tommi Johnsen, PhD
Tommi Johnsen is the former Director of the Reiman School of Finance and an Emeritus Professor at the Daniels College of Business at the University of Denver. She has worked extensively as a research consultant and investment advisor for institutional investors and wealth managers in quantitative methods and portfolio construction. She taught at the graduate and undergraduate levels and published research in several areas including: capital markets, portfolio management and performance analysis, financial applications of econometrics and the analysis of equity securities. In 2019, Dr. Johnsen published “Smarter Investing” with Palgrave/Macmillan, a top 10 in business book sales for the publisher. She received her Ph.D. from the University of Colorado at Boulder, with a major field of study in Investments and a minor in Econometrics.Currently, Dr. Johnsen is a consultant to wealthy families/individuals, asset managers, and wealth managers.
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Important Disclosures
For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. Third party information may become outdated or otherwise superseded without notice. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency has approved, determined the accuracy, or confirmed the adequacy of this article.
The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees. Our full disclosures are availablehere.Definitions of common statistics used in our analysis are availablehere(towards the bottom).
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