Working Paper: CEPR ID: DP12885
Authors: Leland E. Farmer; Lawrence Schmidt; Allan Timmermann
Abstract: 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 little or no evidence of return predictability. We document this empirically using a flexible non-parametric approach and explore possible explanations of this finding, including time-varying risk premia. We find that short-lived predictability pockets are inconsistent with a broad class of affine asset pricing models. Conversely, pockets of return predictability are more in line with a model with investors' incomplete learning about a highly persistent growth component in the underlying cash flow process which undergoes occasional regime shifts.
Keywords: predictability of stock returns; incomplete learning; Markov switching; predictive systems; cash flows; affine asset pricing models
JEL Codes: No JEL codes provided
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Predictor variables (like the T-bill rate) (C29) | Stock market returns (G17) |
| Return predictability (C53) | Pockets of predictability (D80) |
| Local predictability (D80) | Incomplete learning about persistent growth components in cash flows (D25) |
| Short-lived predictability pockets (D84) | Inconsistency with broad classes of affine asset pricing models (G19) |
| Presence of substantial return predictability (G17) | Need for alternative explanations (C59) |