Perasan & Timmermann - Predictability of Stock Returns, Robustness and Economic Significance.

American Finance Association
Predictability of Stock Returns: Robustness and Economic Significance

Author(s): M. Hashem Pesaran and Allan Timmermann
Source: The Journal of Finance, Vol. 50, No. 4 (Sep., 1995), pp. 1201-1228
Published by: Blackwell Publishing for the American Finance Association
Stable URL: http://www.jstor.org/stable/2329349 .
Accessed: 13/06/2011 22:53
Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at .
http://www.jstor.org/page/info/about/policies/terms.jsp. JSTOR's Terms and Conditions of Use provides, in part, that unless
you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you
may use content in the JSTOR archive only for your personal, non-commercial use.
Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at .
http://www.jstor.org/action/showPublisher?publisherCode=black. .
Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed
page of such transmission.
JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of
content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms
of scholarship. For more information about JSTOR, please contact [email protected].
Blackwell Publishing and American Finance Association are collaborating with JSTOR to digitize, preserve
and extend access to The Journal of Finance.
http://www.jstor.org
THE JOURNALOF FINANCE . VOL.L, NO. 4 a SEPTEMBER1995
Predictability of Stock Returns:

Robustness and Economic Significance
M. HASHEM PESARAN AND ALLAN TIMMERMANN*
ABSTRACT
This article examines the robustness of the evidence on predictability of U.S. stock
returns, and addresses the issue of whether this predictability could have been
historically exploited by investors to earn profits in excess of a buy-and-holdstrategy
in the market index. We find that the predictive power of various economicfactors
over stock returns changes through time and tends to vary with the volatility of
returns. The degree to which stock returns were predictableseemed quite low during
the relatively calm markets in the 1960s, but increased to a level where, net of
transaction costs, it could have been exploited by investors in the volatile markets
of the 1970s.
MANY RECENTSTUDIESCONCLUDE that stock returns can be predicted by means of

publicly available information, such as time series data on financial and
macroeconomicvariables with an important business cycle component.' This
conclusion seems to hold across international stock markets as well as over
different time horizons. Variables identified by these studies to have been
statistically important for predicting stock returns include interest rates,
monetary growth rates, changes in industrial production,inflation rates, earn-
ings-price ratios, and dividend yields. However, the economic interpretation of
these results is controversial and far from evident. First, it is possible that the
predictable components in stock returns reflect time-varying expected returns,
in which case predictability of stock returns is, in principle, consistent with an
efficient stock market. A second interpretation takes expected returns as
roughly constant and regards predictability of stock returns as evidence of
stock market inefficiency. It is, however, clear that predictability of excess
returns on its own does not imply stock market inefficiency, and can be
* Pesaran is from Trinity College, Cambridge.Timmermannis from University of California,
San Diego. This is a substantially revised and abridgedversion of the paper "TheUse of Recursive
Model Selection Strategies in Forecasting Stock Returns," Department of Applied Economics
Workingpaper No. 9406, March 1994, University of Cambridge.We would like to thank a referee
and the editor, Ren6 Stulz, as well as seminar participants at The London School of Economics,
The University of Exeter, The Bank of England, University of Southern California,and University
of Californiaat San Diego for helpful comments on the earlier version. The first author gratefully
acknowledges financial support from the Economicand Social Research Council and the Newton
Trust of Trinity College, Cambridge.
1 See, for instance, the articles by Balvers, Cosimano, and McDonald(1990), Breen, Glosten,
and Jagannathan (1990), Campbell(1987), Cochrane(1991), Fama and French (1989), Ferson and
Harvey (1993), French, Schwert, and Stambaugh (1987), Glosten, Jagannathan, and Runkle
(1993), Pesaran and Timmermann(1994a).
1201
1202 The Journal of Finance
interpreted only in conjunction with, and in relation to, an intertemporal

equilibrium model of the economy. Inevitably, all theoretical attempts at
interpretation of excess return predictability will be model-dependent, and
hence inconclusive (see Fama (1991)).
An alternative approach to evaluating the economic significance of stock
market predictability would be to see if the evidence could have been exploited
successfully in investment strategies. This can be done in two ways: One
method would be to evaluate the track records of portfolio managers in "real
time," and see if these portfolios systematically generate excess returns. The
main strength of this approach lies in the fact that it ensures that investors'
portfolio decisions are based exclusively on historically available information.
However, it does not provide much information on which specific factors have
been responsible for predicting stock returns, nor does it guarantee that the
information used by portfolio managers has been publicly available. An alter-
native approach, which explicitly addresses these issues, is to simulate inves-
tors' decisions in real time using publicly available information on a set of
factors thought a priori to have been relevant to forecasting stock returns.
Clearly, caution needs to be exercised when following this research strategy. In
particular, it is important that, as far as possible, rules for prediction of stock
returns are formulated and estimated without the benefit of hindsight. Most
articles in the finance literature report excess return regressions estimated on
the basis of the entire sample of available observations or on substantial
subsamples of the data, which, for the purpose of trading, is clearly inappro-
priate, as in "real time" no investor could have obtained parameter estimates
based on the entire sample. A similar consideration also applies to the choice
of the forecasting model. Any analysis of stock market predictability that
focuses on a particular forecasting model, taken as known with certainty over
the whole sample period, can be criticized for ignoring the problem of "model
uncertainty" and the impact this is likely to have on investors' portfolio
strategy in "real time." When the same forecasting model is used over the
whole sample period, it inevitably raises the possibility that the choice of the
model could have been made with the benefit of hindsight.
The purpose of this article is to assess the economic significance of the
predictability of U.S. stock returns, explicitly accounting for the forecasting
uncertainty faced by investors who only have access to historical information.
Rather than assuming that investors somehow historically knew that a spe-
cific forecasting model was going to perform well, we make a much weaker
assumption about investors' beliefs over the sort of business cycle and financial
variables thought as being potentially important in forecasting stock returns.
Based on these beliefs, we assume that agents establish a base set of potential
forecasting variables and, at each point in time, search for a reasonable model
specification, capable of predicting stock returns, across this set. Notably, this
procedure assumes that, at each point in time, investors use only historically
available informationto select a model accordingto a predefinedmodel selection
criterionand then use the chosen model to make one-periodahead predictionsof
excess returns. The recursiveforecasts are then employedin a portfolioswitching
Predictability of Returns: Robustness, Economic Significance 1203
strategy accordingto which shares or bonds are held dependingon whether excess
returns on stocks are predictedto be positive or negative.
A third factor that needs to be taken into account when simulating investors'
portfoliodecisionsin "realtime"is transactioncosts. We analyze portfolioreturns
for zero, low, and high transaction cost scenarios to shed light on whether the
predictablecomponentsin stock returns are economicallyexploitablenet of trans-
action costs. Finally, we also considerthe publicavailabilityof statistical methods
and computertechnologyused by investors to computeone-step ahead forecastsof
excess returns. In developingour forecastingequations we use simple statistical
and computing techniques that clearly were publicly available to any investor
throughout the sample period analyzed in this paper. We also provide evidence
based on forecasting techniques that were not available until well into the sev-
enties, since this offers important insights into the potential usefulness of our
methodology for forecasting of stock returns in the future. The availability of
different model selection criteria also raises the issue of uncertainty over the
choiceof modelselection criteria.This problemis addressedin an Appendixwhere
a new profit-basedhyper-selectionprocedureis proposed.
The plan of the article is as follows: Section I discusses how to identify
predictability of stock returns. Section II sets up the real time simulation
experiments and reports the main prediction results for the monthly observa-
tions on U.S. stock returns. The economic significance of the predictions is
assessed through their use in a trading strategy in Section III, and Section IV
provides a discussion of the main findings.
I. Identifying Predictability of Stock Returns:

A Recursive Modeling Approach
Consider an investor who believes that stock returns can be predicted by
means of a set of financial and macroeconomicindicators, but does not know
the "true"form of the underlying specification, let alone the "true"parameter
values. Under these circumstances the best the investor can do is to search for
a suitable model specification among the set of models believed a priori to be
capable of predicting stock returns. As time progresses and the historical
observations available to investors increase, the added information is likely to
lead the investor to change the forecasting equation unless, of course, the
investor holds very strong prior beliefs in a specific model. Here we consider an
open-minded investor with no strong beliefs in any particular model. The
evolution of forecasting models over time may reflect the learning process of
the investor or the changing nature of the underlying data generating process,
or both. In practice it will be difficult to disentangle these two effects.2
2 A similarrecursivemodellingstrategyhas also been consideredby Phillips(1992)and Phillipsand

Ploberger(1994)in the contextof univariateautoregressive-moving averageprocesses.However,their
workis best viewedas recursiveestimationof the orderof the AutoregressiveMovingAverageprocess,
and does not involvesearchingover subset of regressorsas we do in this paper.Also see the discussion
of the hyper-selectioncriterionin the Appendix,where the recursive modelling strategy is further
extendedto allow for the uncertaintyover the choiceof model selectioncriterionitself.
Suppose that, at each point in time, t, an investor searches over a base set of
K factors or regressors to make one period ahead forecasts of excess returns
using only information that are publicly available at the time.3 We simulate
investor's search for a forecasting model by applying standard statistical
criteria for model selection, as well as financial criteria, to the set of regression
models spanned by all possible permutations of the K factors/regressors {xl,
X2X . . . XXKjin the base set.4This gives a total of 2Kdifferentmodels,each of
which is uniquely identified by a number, i, between 1 and 2K.Consider a K X
1 selection vector, vi, composedof ones and zeros where a one in itsjth element
means that the jth regressor is included in the model, whereas a zero in its jth
element means that this regressor is excluded from the model. Then model i
(denoted by Mj) can be represented by the K-digit string of zeros and ones
corresponding to the binary code of its number. Denoting the number of
regressors included in model Mi by Ki, then Ki = e' vi, where e is a K X 1 vector
of ones. Suppose that pT,the excess return at time T, is forecast by means of
linear regressions
Mi : P =T+1 iTi + 1,i
T = 1, 2, ..., t 1. (1)
where XTi is a (Ki + 1) X 1 vector of regressors under model Mi, obtained as

a subset of the base set of regressors, XT, chosen by the investor at the
beginning of the experiments, plus a vector of ones for the intercept term.
Conditional on model Mi and given the observations p+1, XTi, X = 1, 2, ....
t - 1 (with t -K + 2), parameters of model Mi can be estimated by the
ordinary least squares (OLS) method. Denoting these estimates by 't i we
have
for t =K+ 2,K+ 3,...,)T, 2

(
E= XX ) ' T' , and i = 1, . , 2 .
The OLS estimates are fairly simple to compute (even in the early 1960s) and,
in view of the Gauss-Markov Theorem, are reasonably robust even in the
presence of nonnormal errors in the excess return equation.
The particular choice of XTjto be used in forecasting of PT+ican be based on
a number of statistical model selection criteria suggested in the literature,
such as the R2, Akaike's Information Criterion (AIC) (Akaike (1973)), or
Schwarz's Bayesian Information Criterion (BIC) (Schwarz (1978)).5 These
3 In this article we shall make the simplifying assumption that the base regressors remain in
effect over the whole sample period. However, in principle, one can also consider the possibility of
revising the base set once clear indications of "regimeswitches" are established.
4 An intercept term is included in all the excess return regressions consideredby the investor.
5 There are, of course, other criteria that couldbe used for choosingthe subset of regressors used
to compute the forecasts. Prominent examples are Mallows'(1973) Cpcriterion,Amemiya's(1980)

prediction criterion, and the Posterior InformationCriterionrecently proposedby Phillips (1992)
and Phillips and Ploberger (1994). However, in this article we focus on the more often used and
familiar model selection criteria.
criteria are likelihood-based and assign different weights to the "parsimony"

and "fit"of the models. The "fit"is measured by the maximized value of the
log-likelihood function (LL), and the "parsimony"by the number of freely
estimated coefficients. At time t, and under model Mi, we have
-t
LLti= 2 {1 + log(27orti)}, (3)
where
t-1
tO E (PT+1 -XT,'i~i)2It (4)

T=O
The Akaike and Schwarz model selection criteria can be written as
AICtj = LLtj - (Ki + 1), (5)
BICt i= LLt - 1/2(Ki + 1)log(t). (6)
The R2 criterion, originally suggested by Theil (1958) as a criterion for select-

ing regressors in a linear regression model, is given by
= 1 - S2
Rtji (7)
pt
where &t~is the unbiased estimator of a2 given by &t2= (P+? -

Xfriti)i~ -Ki- 1), and S2 = 1 (pa - pt)2/(t - 1) is the sample variance
for the first t observations on p, and Pt = t1 T= 1 pT. The R2 criterion can also
be written explicitly as a trade-off between fit and parsimony:
TCt i= LLt i- 1/2 log t - ki - 1 (8)
It is easy to show that, in the context of linear regression models, the R2i and
the TCt i criteria are equivalent, in the sense that they select the same model.
We also considered a model selection criterion based on a measure of direc-
tional accuracy, on the grounds that investors in practice often are interested
in predicting the switches in the sign of the excess return function and not
necessarily the magnitude of changes in the excess returns. The derivation of
the 'sign' criterion (SC) based on the directional accuracy of the forecasts
involves two steps. In the first step, one finds the set of regressors that
maximize the proportionof correctlypredicted signs of the excess returns given
by
it
SCt= - > {I(p)(Ti) + (1 - I - J(pTt))}, (9)
T=1
where I(p) is an indicator function that takes the value of unity if p1> 0, and
zero otherwise, and P - is the forecast of p. based on model Mi. In the case of a
draw, i.e., when two or more models correctly predict the same (maximum)
proportionof signs of excess returns, a second step selects a model recursively
according to the R2 criterion.
From the point of view of assessing the market value of predictability of
stock returns, the above statistical criteria can, however, be criticized on the
grounds that they do not take account of transaction costs, and are not
necessarily in accordance with the investor's loss function. To deal with these
shortcomings, we use a forecasting strategy that directly maximizes financial
criteria. In particular we consider a "recursivewealth" criterion and a recur-
sive Sharpe ratio.6 The recursive wealth criterion maximizes the cumulated
wealth obtained using forecasts from model Mi in a switching portfolio, which
we refer to as portfolio i, at time t. The cumulative wealth from such a portfolio
at time t is given by
Wt i = Wo f7 (1 + rT,i), (10)
7=1
where rTi is the period T return (net of transaction costs) on portfolio i,

constructed on the basis of the excess return forecasts from model Mi. The
returns rTi depend on the nature of the trading rule, the transaction costs and
the whole sequence of excess return forecasts, risk free interest rates, stock
prices and dividends prior to period T.For an example of the sort of trading rule
that we have in mind, see Section III.
The Recursive Sharpe Criterion maximizes the ratio of the mean excess
return on portfolio i to its standard deviation:
it
t E(rTi- l1T
7=1
Sharpet,i = , (11)
it
t- 1 E (rTi -rt)2
where II is the return on a 1-month T-bill held from the end of one month to
the next, and Tti = t-1 Et=, r
We applied all the above model selection criteria to the linear regressions.
For each of the criteria, and based on data up to period t, the model with the
highest value for the criterion function was chosen to forecast excess returns
for period t + 1. For example, in the case of the recursive Sharpe criterion, the
selected model was that which maximized Sharpet,i given by (11) over all of the
2k portfolios, i = 1, 2, 3, ..., 2k. Notice that our approach makes only very
6
We are grateful to a referee for drawing our attention to this work.
weak assumptions about the underlying data generating process (DGP). We do

not assume that the DGP is necessarily fixed throughout the sample period,
and at each point in time we use the different model selection criteria simply
as a tool for obtaining an approximate forecasting equation. This procedure
treats all models under consideration as equally likely. Choosing a particular
model at time t does not necessarily restrict the model choice at subsequent
periods.
When interpreting the results reported in Sections II and III below, however,
it is important to recognize that neither the AIC nor the BIC was publicly
available until well into the 1970s. The main property of the BIC criterion is
that, under certain regularity conditions, it will asymptotically select the
"true"model, provided of course that the 'true' model is contained in the set of
models over which the search is conducted.7Neither Akaike's criterion nor the
R2 criterion is consistent, in the sense of selecting the "true"model, as the
sample size increases without bounds. In the context of forecasting stock
returns where the "true" model or the correct list of regressors is clearly
unknown and may be changing over time, the consistency property of a model
selection criterion is not as important as it may appear at first. Both the R2 and
the AIC, although statistically inconsistent, have the important property of
yielding an approximate model. The primary aim is to select a forecasting
equation that could be viewed at the time as being a reasonable approximation
to the data generating process. Akaike's criterion has been shown by Shibata
(1976) to strike a good balance between giving biased estimates when the
order of the model is too low, and the risk of increasing the variance when too
many regressors are included. Finally, for the purpose of our exercise, the R2
has the advantage of being extensively used by economists to evaluate model
performance.
II. Recursive Predictions of U.S. Stock Returns

When simulating the historical process through which an investor may
attempt to forecast stock returns, it is important to establish the sort of
variables the investor is likely to consider using in modeling stock returns, the
criteria he/she adopts to select a particular forecasting model, and the estima-
tion procedure applied.
In this section we explain the choice of the base variables that we assume
will be considered by investors in forecasting stock returns, and in the next
section we explain the estimation and forecasting procedure in more detail.
The starting point of our analysis is the long tradition in finance that links
movements in stock returns to business cycle indicators. For instance, in his
book Investment for Appreciation. Forecasting Movements in Security Prices.
Techniques of Trading in Shares for Profit published in 1936, Angas writes
that "Themajor determinant of price movements on the stock exchange is the
business cycle." (p. 15). Other examples of early studies that emphasize the
7 See, for example, P6tscher (1991) and the references cited therein.
systematic variation of stock returns over the business cycle include Prime
(1946). Dowrie and Fuller (1950), Rose (1960), and Morgan and Thomas (1962).
Variables suggested by these studies to be systematically linked with stock
returns include short and long interest rates, dividend yields, industrial pro-
duction, company earnings, liquidity measures, and the inflation rate.
Based on a review of the early literature (see Pesaran and Timmermann
(1994c)) we established a benchmark set of regressors over which the search
for a "satisfactory"prediction model could be conductedby a potential investor.
The set consists of a constant, which is always included in the model, as well
as nine regressors, namely Xt = {YSPt-1, EPt-1, I't-1, Ilt-2, I12t-1, I12t-2,
rt-2, AIPt-2, AMt-2}, where YSP is the dividend yield, EP is the earnings-price
ratio, Ii is the 1-month T-bill rate, 112 is the 12-month T-bond rate, 11is the
year-on-year rate of inflation, AlIPis the year-on-year rate of change in indus-
trial output, and AM is the year-on-year growth rate in the narrow money
stock. All variables computed using macroeconomicindicators, such as, AIP
and AM, were measured using 12-month moving averages to decrease the
impact of historical data revisions on the results.
The early studies of stock returns are not always clear on what they consider
to be the appropriate time lags between the changes in the business cycle
variables and stock returns. Here, following standard practice in finance, we
decided to include the most recently available values of the macroeconomic
variables in the base set of regressors. The lag associated with the publication
of macroeconomicindicators means that these variables must be included in
the base set with a 2-month time lag. Since the dividend and earning yields are
based on 12-month moving averages, only a one period lag of these variables
was included in the base set. To allow for the possibility, often mentioned in
financial studies, that changes in interest rates rather than their absolute
levels affect stock returns, we also included a two month as well as a one month
lagged value of the interest variables.
A. Data Sources
All variables were measured at monthly frequencies over the period 1954(1)
to 1992(12), and the data sources were as follows: Stock prices were measured
by the Standard & Poor's 500 index at close on the last trading day of each
month. These stock indices, as well as a monthly average of annualized
dividends and earnings, were taken from Standard & Poor's Statistical Ser-
vice. The 1-month T-bill rate was measured on the last trading day of the
month and computed as the average of the bid and ask yields. The source was
the Fama-Bliss risk free rates file on the Center for Research in Security Prices
(CRSP) tapes. Similarly, the 12-month discount bond rate was measured on
the last trading day of the month, using the Fama-Bliss discount bonds file on
the CRSP tapes as the data source. The inflation rate was computed using the
producer price index for finished goods (source: Citibase), and the rate of
change in industrial production was based on a seasonally adjusted index for
industrial production (source: Citibase). The monetary series were based on
the narrow monetary aggregates published by the Federal Reserve Bank of St.
Louis and provided by Citibase. Finally, the dependent variable, excess re-
turns on stocks, Pt, was computed as Pt = (Pt + Dt - Pt-,)/Pt-, - Ilt-1, where
Pt is the stock price, Dt is dividends and IltJ1 is the return from holding a
1-month T-bill from the end of month t - 1 to the end of month t.
The recursive model selection and estimation strategy was based on monthly
observations over the period 1954(1) to 1992(12). The year 1954 was chosen as
the start of the sample for estimation, since reliable monthly measures for
most macroeconomic time series start to become available only after the
Second World War. Also, it was only after the "accord"between the Fed and the
Treasury in March 1951, and after the presidential election in 1952, that the
Fed stopped pegging interest rates and began to pursue an independent
monetary policy (see Mishkin (1992), p. 453). As far as trading in stocks and
bonds are concerned, we took a rather conservative stand and commenced with
the trading at the start of 1960, thus using 6 years of monthly observations as
a preliminary "training" period for estimation. As noted above, by the early
1960s, a number of studies had already suggested the possibility that stock
returns may be varying systematically over the course of the business cycle.
In each case the model selection criteria set out in Section I were applied to
linear regression models using the excess returns on the S & P 500 portfolio as
the dependent variable and subsets of the base set of regressors as the inde-
pendent variables. For our set of nine regressors, this means comparing 29 =
512 models at each point in time, and over the period 1959(12) to 1992(11) this
gives a total of 202,752 regressions to be computed. Of course, we do not
literally assume that investors proceeded with these computations, but we
emphasize the simplicity of the individual steps involved in such a forecasting
procedure: OLS estimation of the models, followed by model selection using
simple choice criteria and then computation of a one-step-ahead forecast. We
also computed forecasts of monthly excess returns based on a model that
included the entire set of regressors. There is no specification uncertainty
associated with this last procedure, according to which only the parameter
estimates are updated recursively in light of new monthly observations.
To summarize, the recursive model specification proceeds as follows: in
1959(12) the values of the selection criteria are computed for each of the 512
possible combinations of regressors from the base set using monthly data over
the period 1954(1) to 1959(12). An intercept term is included in all the regres-
sions. The model that maximizes the discriminant function of a given model
selection criterion is chosen, and the parameter values estimated with obser-
vations over the 1954(1) to 1959(12) period are used to forecast excess returns
for 1960(1). To forecast monthly excess returns for 1960(2), the procedure is
repeated for all the 512 models using monthly data over the period 1954(1) to
1960(1), and so on. Thus, although computationally demanding, our selection
procedure clearly simulates the search procedure which an investor could have
carried out in real time. It also captures the possibility that an investor may
switch from one model to another in light of new empirical evidence obtained
as the sample size expands.
Figure1. RecuItbr-sieoexces
Creturno foecst uneratentiemoelsletonsrae
As the previous sectionmakes

emMad clea, we atotl 2
of mdTiel 5
M-hwrlly Obsef~-r-V -ttoihy Ob.-rtGtio
gies, 1960(1)to 1992(12). . l~"l, 19 'l I'19. 91 W1Il #1 97 ''
ovet 1a965912) to5 99 9(1 eri15

5 1t7 I) 19Ce9arly ,V7 19we1 17
cann su71 1p1 te93 1X75
19rea era wit
allgthe d.Returaio e s ltentimtovie

es n fo ts s pheiction
grael diste-
plas of th man2eslt.
plays o the manott resulvts. atit bevto
returns linearreletonsraesso
m s 1.Recursivheprdceio excess
Figure
esthepreimated sfoeatsudraltedrnative
manslected accordi to
rerstivte th fourmodels
r1951,Rshow:Hw
sel.Emigreca1
namlye 19B92l)
s p IC,
the
ous IC,
Cle any S.
prdcePxesreturnsabasedy hen
bott
supp
on reande
the oi th f
lieaurnrgrssio
Sthek
the
alsolshows atuas
o f theexcesstin returonaderesditioon from a
recursively estimated equation with all the nine variables in the base set
included as regressors.9 The recursive predictions based on the various model
selection criteria have very similar patterns showing quite a high degree of
volatility, especially during the early 1980s. This coincides with the period of
high volatility of nominal interest rates resulting from changes in the operat-
The data files and the details of the estimation and forecastingresults are available from the
8
authors on request.
mNotice, however, that the figures giving the recursive forecasts have a different vertical scale
than the actual values of the excess returns. Due to the relatively high variance of actual excess
returns plotting the excess return forecasts and their realizations on the same scale would have
obscured the differences that exist between the different recursive forecasts.
Predictability of Ret urns: Robustness, Economic Significance 1211
4o.1t63 -6 -l 1,L;l -3 s tv I5' .1 "83I" 98 BS'. 16, M 11~91,I.AI

'~.D
II' 1931115
11, I-- 1- .6 I- I--
smallerthan ~~~~~~~~~~Mthey
volatility ofth ctaleceseurs
Figure 2. Shwtestandard errors of recursive excessrqainnelegrnaiessionsl

return
udrtedfeetmdlselection
strategies.,In9al0casesthe1recrsivel
esimatroedurstandardwerrorsthaeaFendencya tinerveasetovere ien patebrticular,
sutbstantialNo
increasesgin the
estmatdatandard erors canbrediclearlyisee inc
1962,e 194,andth voafterit the Otober 1987a stocks matrken rah10Ipotn
Finformatiosons the extanter forrecsting pecrformanxcesof rtherdifegrntsmodel
is strategies.
udrtedfeetmdlselection alsopoieln iue3 hchipayses the recursively
comubtediasquaredalues of
theestimpled condrreato roefficient (re bletwyeen the
recursive forecasts obtained under the different model selection criteria and
the actual excess returns. The fit of the recursive forecasts is relatively high in
the early 1960s (with values of the r2 being around 0.20), and increases
substantially during 1962, but then starts to decline until the early 1970s.
With increased volatility of the markets in 1974, the fit of the recursive
10 The recursive standard error estimates in Figure 2 show the trend in volatility of excess
returns conditional on the information in the base set of regressors. Similar trends can also be seen
in unconditional measures of volatility, such as the recursively estimated standard deviations of
the actual excess return series.
m-etbre-cusiey Ob--U co sr n ff Obe-tweei-n
.,_ SP-;_1X,M. T--' 8; t i I
fr, ? IOCX a -8 1st 5 s, 06SS 1B7as 090Bmaue 101 1973

r..., 1975 1977 1Vby 9 81tga R~
193 jup 85 191[7
, 1989 t1t
tsr d 9r
ma 16 9S 1s 0.12 99 ]7
to ? aon S >0 *80|",
. .18 'W 9 and 97 'e then 9r
again startsMtohelin steailyup

once o te ed -o th sampl, wee ttae
a value 3of around i.1 frmels selected acodn othe
12(12 aNe TheAki
Critureri an 0.1 modelsrselleced
filor usinglthe criterion.
SchatbrzS tween
soreckmart in easured si g nificantl around1.9, ,th predi ,b it, of stoc

3aue
tfogehrFigures1n2h andua
Toeaken althughteroatltsi.heUS
sow thatxcs
astmarsured bycin
rneturans of the
reusvsoeastprlaie,
stheafityuohn towhereiatuale
earlyen1962ehere thgues2 volatilit thet marketugalsol etilnt up le toSa
d
simil markecoincluin. cogntricastt in4the sredictandardy eorstock
increase
swichs"l hee theoud01 markets
o arselactivl a
neted ih nvestorhaepkar-
oFture r cursive forecastreturn aftr ,thndrdngt
equations tob 1987 stocthematr
rticularluncertain ofrwhichlforecastingumode tohuefohwrzcrteraiong.Thepsd
calrer, ini ctinrensg ith this epieode hais suomewhatdifferent fbromthe onestin
4.
1re962sman1in7ed e aculaly onouncess perns.
simil arkcocuion.creaotrstedh incread
1974 the
prditability erofrstc
forsachs" ohefr thevariets insignificantly
the bsee orunsegstsors aTbendpvese ant then
rtrsasmauebyteftof the forecasting
recursive afto Otbr18socmarktua
the
ecenagleofunperids wh foreequlativemodelrss including ther caurnsv the sei e
mdels nAs
criteri, herxpe
togbe
aloindcrating batla
thathethisond thea
epeisode This suggewt theAkalikecite ia tend
antdc hatdifrenitabilithe toU
onestoc
Forichs wher thevariabets inrte beaseivetlyunettled Table

inetr preset par-
a
perahcointaeideridswiher deliegrsosicue in the
vaurfrfraltecursiely selection
models. As to be expected, on balance the R2 and the Akaike criteria tend to

Table I
Percentage of Periods Where a Regressor is Included
in Forecasting Equations
The results are based on monthly excess return equations selected and estimated recursively over
the period 1960(1) to 1992(12). Each month the set of regressors that maximizes a given model
selection criterion was determined and used to forecast stock returns one month ahead. For a
definition of the statistical model selection criteria, see Section II of the article. The regressors are
YSP(- 1) = dividend yield lagged one period, EP(- 1) = earnings-price ratio lagged one period
I1(-1) = one-month T-bill rate lagged one period, I1(-2) = one-month T-bill rate lagged two
periods, 112(- 1) = twelve-month T-bill rate lagged one period, 112(-2) = twelve-month T-bill rate
lagged two periods, fl(-2) = inflation rate lagged two periods, AIP(-2) = change in industrial
production lagged two periods, and AM(-2) = monetary growth rate lagged two periods.
Percentages
Selection
Criteria YSP(-1) EP(-1) I1-1) I1(-2) 112(-1) 112(-2) II(-2) AIP(-2) AM(-2)
Akaike 70.5 9.6 98.5 25.0 27.0 31.3 51.8 74.7 84.6
Schwarz 62.9 0.0 93.9 22.0 2.8 34.8 0.0 8.8 28.3
A2 69.7 20.5 99.2 23.0 44.7 42.9 55.8 87.9 89.6
Sign 62.4 44.2 72.5 54.8 49.7 50.0 59.6 58.6 76.5
select more regressors than does the Schwarz criterion. The latter criterion
imposes a much heavier penalty for inclusion of an additional regressor than
do the former criteria, and this difference becomes particularly marked as the
sample size is increased from 72 to 468 observations over the 1960 to 1992
period.
An alternative, and in many respects more comprehensive, method of exam-
ining the robustness of the factors contributing to the predictability of stock
returns would be to consider the time-profile of the inclusion frequencies of the
different factors in the forecasting model. The graphs in Figure 4 provide such
time-profiles for the R2 criterion, and show the periods in which a regressor is
included (the graph takes a value of 1) or excluded (the graph takes a value of
0) from the model used for the one-period ahead prediction of excess returns.
Similar graphs for the other model selection criteria are also available from the
authors, and are not presented here to save space." Since we are searching for
a model specification over a large number of time periods and across different
combinations of regressors, it is possible that a regressor occasionally gets
included by chance and not because it is statistically significant for prediction
of excess returns. In such cases, however, it is unlikely that the regressor
under consideration will be included in the forecasting equation for long in
subsequent periods. In contrast, when a regressor is selected in a large pro-
portion of the time periods and on a continuous basis, then it is reasonable to
11The results for the Akaike criterion were very close to those for the R2 criterion. The Sign
criterion did not provide much information about periods in which specific regressors are included.
Because of the discontinuous nature of this criterion, the number of switches between periods
where a variable is included in the model and periods where it is excluded from the model is much
higher for the Sign criterion than for any of the other model selection criteria.
Figure4;.dIncluso frequeny of th variablesin~

Nthe baes udrteR
t oe
seecio cr3'iterIonie190 " 1)t '1992(12). 97 incusoof. 'the variable in

Note The the6 regressiW$on
Obyunty, and zero otherwise.
is depicted,
model
question Rto
-~h.""t in-.t
regrsso
expect~~~~Rthe an"impotant fac--t
be.W in genertinMthe
-tor4.ob
obsrvepred" 1of stock retrn.

.7 9316Ictability- 111.119 a - 9,1. 1 .111 MI -
theqecdiidn
Figure 4 showsuthat yielvariablesith iaseselete indemost pemodsl
from 1970 onwards. This finding supports the many recent studies that find
the yield variable to be statistically significant in predicting stock returns (e.g.,
Campbell (1987), Fama and French (1989)). Our results, however, suggest that
the correlation between yields and excess returns has become particularly
strong only after 1970.12 Compared to the dividend yield variable, the earn-
ings-price ratio lagged one month is not selected as often in the forecasting
models; in fact, this regressor is never chosen by the Schwarz criterion.
The 1-month interest rate variable lagged one month is excluded in the
forecasting models in most periods (see Figure 4), whereas the two-month
lagged value of the 1-month interest rate, I't-2, is included as a regressor in
the forecasting models mainly during the 1975 to 1982 period. In the case of
the longer interest rate lagged one month, J12t-1, it is clear from Figure 4 that
this variable is selected by the R2 criterion (but not by the Schwarz criterion),
during the 1976 to 1979 periods, and again after 1982. This is an interesting
finding since the periods when the J12t-1 variable is not included in the
forecasting model coincide closely with the period from October 1979 to Sep-
tember 1982, when the Federal Reserve ceased to target interest rates. It
suggests that the 12-month interest rate has predictive power over excess
returns in regimes where the Federal Reserve targets interest rates, but not in
regimes where monetary aggregates are targeted. A similar conclusion also
emerges with respect to the 12-month interest rate lagged two months, 112t-2.
Using the R2 model selection criterion, the inflation variable lagged two
periods (t-2) is included in the forecasting equations primarily after the first
oil shock. In contrast, the Schwarz criterion does not select this variable at all.
Figure 4 also shows that the rate of change in industrial production lagged two
periods (AlPt-2) tends to be included in the forecasting models from 1964
onwards, when the R2 model selection criterion is adopted. Once again, by
comparison the Schwarz criterion rarely selects the lPt-2 variable. Finally,
using the R2 criterion, the money growth variable, \Mt-2, gets selected con-
tinuously from 1964 onwards, but the same is not true when the Schwarz
criterion is considered, which selects the money growth variable 28 percent of
the times.
The different outcomes obtained under the R2 and the Akaike Criteria on the
one hand, and under the Schwarz criterion on the other, lies in the fact that
the Schwarz criterion penalizes inclusion of variables more heavily than
either the Akaike or the R2 criteria. This may be a drawback for the Schwarz
criterion since, in the event of a structural break in the underlying data
generating process, this criterion may detect the change at a slower rate than
the other criteria.
In a recent study, Bossaerts and Hillion (1994)13 also find evidence support-
ing the conclusion that the best prediction model for monthly stock returns
changes over time. Bossaerts and Hillion compare the in-sample and out-of-
sample forecasting performance of models selected according to a variety of
standard model selection criteria and develop a new model selection criterion
12 On this point see also the recent papers by Goetzmannand Jorion (1993) and Nelson and Kim
(1993), who find that, after correctingfor lagged endogenousvariable bias, the correlationbetween
lagged values of the dividend yield and excess returns on stocks is particularly strong after the
Second WorldWar.
13
We are grateful to an anonymous referee for bringing this research to our attention.
that can be used to detect nonstationarities in the underlying data generating

process. Based on an examination of the out-of-sample forecasts of monthly
returns in 15 countries over the period 1989 to 1993, Bossaerts and Hillion
conclude that there is strong evidence of nonstationarities in stock returns in
the U.S. and several other markets. Notice that an important difference
between our study and theirs is that we explicitly allow the forecasting model
to change through time.
C. The Market Timing Value of The Recursive Forecasts

In a recent study, Leitch and Tanner (1991) found that traditional measures
of forecasting performance,such as the R2,were not as strongly correlatedwith
profits from a trading strategy based on a set of predictions as were a measure
of the directional accuracy (e.g., the proportion of times the sign of excess
returns is correctly predicted) of the forecasts. In Pesaran and Timmermann
(1992, 1994b) we have developed a new market timing test statistic that is
based on the directional accuracy of the forecasts and hence may provide
important information on the economic value of the recursive forecasts. In the
present case with only two directions, our test statistic is asymptotically
equivalent to the Henriksson and Merton (1981) test. (Pesaran and Timmer-
mann (1994b)).14Values of this market timing test statistic, which are asymp-
totically normally distributed, are reported in Table II. For a one-sided test of
the null of no market timing against the alternative of market timing skills,
the 5 percent critical value is 1.64. Using the whole sample, 1960(1) to
1992(12), the null hypothesis is strongly rejected for the predictions based on
models recursively selected according to all criteria except for the Schwarz
criterion. Predictability seems particularly high during the 1970s and is not
statistically significant during the other two decades. This suggests that the
forecasting performanceis not primarily a function of the length of the "learn-
ing period" of the models, as one might have suspected if the underlying
data-generating process had remained constant over time.
The percentage of correctlypredicted signs of the excess returns also conveys
important information to an investor. Once again, with the exception of the
Schwarz criterion, the recursive predictions get the sign of the excess returns
right in at least 58 percent of all months over the 1960 to 1992 period. The
results over the three subperiods, 1960 to 1969, 1970 to 1979 and 1980 to 1989,
also show the substantially higher proportion of correct signs achieved by all
the recursive forecasts over the 1970s as comparedto the other two subperiods.
III. Assessing the Economic Significance of Predictability of

Excess Returns in a Simple Trading Strategy
In the finance literature, the efficient market hypothesis is often interpreted
as the impossibility of constructing a trading rule, based on publicly available
14 The largest deviation between the values of our test statistic and the values of the nonpara-
metric Henriksson-Mertontest statistic reported in Table II was 0.03.

Table II
Predictive Accuracy of Excess Return Forecasts over 1960(1) to
1992(12) and Three Sub-Periods
The PT statistic is the nonparametric test statistic for market timing proposed in Pesaran and
Timmermann (1992). This test, which is asymptotically equivalent to the Henriksson-Merton
(1981) test of market-timing, has a standardized normal distribution in large samples. All selec-
tion criteria were applied recursively (see Section II). The hyper-selection criterion is described in
the Appendix. The recursive wealth procedure uses as a forecasting model the one that, at each
point in time, generated the largest wealth (net of transaction costs) when its forecasts were used
in a simple trading strategy. The recursive Sharpe criterion is based on a similar procedure with
the difference that it is now the Sharpe ratio corresponding to trading results based on the set of
predictions generated by a particular regression model that is being maximized recursively.
1960 to 1992 1960 to 1969 1970 to 1979 1980 to 1989

Proportion Proportion Proportion Proportion
of of of of
Selection PT- Correct PT- Correct PT- Correct PT- Correct
Criteria Statistics Signs Statistics Signs Statistics Signs Statistics Signs
Panel A: Statistical Selection Criteria
3.39* 59.6 1.64t 58.3 2.64* 61.7 0.76 56.7
Akaike 2.88* 58.3 1.33 56.7 2.67* 61.7 0.43 55.0
Schwarz 1.34 53.3 -1.20 43.3 2.39* 60.8 0.73 54.2
Sign 2.93* 58.3 1.92t 59.2 1.88t 58.3 0.79 55.8
All Regressors 3.41* 59.6 1.14 56.7 2.81* 62.5 1.11 57.5
Panel B: Hyper-Selection Procedure
Transaction Costs
Zero 2.88* 58.1 1.92t 59.2 1.88t 58.3 0.85 55.8
Medium 3.06* 58.6 1.92t 59.2 1.71t 57.5 0.95 56.7
High 3.06* 58.6 1.92t 59.2 1.51 56.7 1.11 57.5
Panel C: Financial Criteria
Recursive Wealth Procedure
Transaction Costs
Zero 3.73* 60.4 0.98 55.8 2.64* 61.7 1.67t 60.0
Medium 3.51* 59.6 1.39 56.7 2.25* 60.0 1.51 59.2
High 3.27* 58.8 1.39 56.7 1.88t 58.3 1.58 58.3
Recursive Sharpe Procedure
Transaction Costs
Zero 3.71* 60.4 1.29 57.5 2.62* 61.7 1.90t 60.8
Medium 3.14* 58.8 1.14 56.7 2.62* 61.7 1.07 56.7
High 3.31* 59.1 0.98 55.8 2.62* 61.7 1.20 56.7
* Indicates statistically significant evidence of market timing at the 10 percent level.

t Indicates statistically significant evidence of market timing at the 1 percent level.
information, that is capable of yielding positive excess profits (discounted at an

appropriate risk-adjusted rate). Jensen (1978) puts it this way: "A market is
efficient with respect to information set flt if it is impossible to make economic
profits by trading on the basis of information set Qt."
Predictability of stock returns in itself does not, however, guarantee that an
investor can earn profits from a trading strategy based on such forecasts. First,
monthly excess returns on stocks do not follow a standard distribution but are
considerably more leptokurtic than, say, the normal distribution. Standard

measures of predictive performance, such as the R2, may not be reliable in
terms of indicating opportunities for profit-making.Secondly, transaction costs
may erode the profits from trading in the financial markets based on recursive
forecasts of excess returns. Comparedto the natural benchmark of a buy-and-
hold strategy in the market portfolio, which is a relatively passive investment
strategy and hence incurs low transaction costs, an investment strategy based
on recursive forecasts is likely to incur considerably higher transaction costs
and may not be as profitable as the buy-and-hold strategy when transaction
costs are appropriately taken into account.
To find out if our recursive predictions could have been used to generate a
higher profit than that earned from following a buy-and-hold strategy in the
market portfolio, we used our predictions in a simple switching strategy that
has been employed extensively in the finance literature. According to this
strategy, investors should hold equity in periods where the business cycle
indicators suggest that equity returns are going to outperform returns from
holding bonds (i.e., the predicted excess return on stocks is positive), and
otherwise hold bonds. We do not allow for short-selling of assets, nor do we
assume that investors can use leverage when selecting their portfolios.Also, in
the absence of a published time series on transaction costs during the period
1960 to 1992, we made the simplifying assumption that these are constant
through time and symmetric with respect to whether the investor is buying or
selling assets. We further assume that transaction costs are proportionalto the
value of the trade, letting c1 and c2 be the percentage transaction costs on
shares and bonds, respectively.15
To analyze how the value of the investor's portfolio evolves through time, we
first introduce some notations. Let Wtbe the funds available to the investor at
the end of period t, Nt the numbers of shares held at the end of period t (after
trading), Pt the price of shares at the end of period t, Dt the dividends per share
paid during period t, rt the rate of return on bonds in period t, Bt the investor's
position in bonds at the end of period t (after trading), and ItJ1(pt?l) the
indicator variable, as defined earlier, which takes the value 1 or 0 accordingto
the predicted sign of excess returns in period t + 1, namely: It+ 1Pt+ 1) = 1, if
Pt+i > 0, and t+?1(?t+,) = 0, otherwise. For simplicity we also refer to this
function as It+1.
At a particular point in time, t, we assume that the funds are held entirely
either in bonds or in stocks, according to the value predicted for It+.1 Net of
transaction costs the investor can allocate the funds either to shares or to
bonds:
Nt = Wtlt+,(l - c1)/Pt, (12)
Bt= Wt(1 - It+1 - c2). (13)
15
For a more detailed discussion of transaction costs and their relation to commissionfees and
bid-ask spreads, see Pesaran and Timmermann(1994a).
For period t + 1, the budget constraint of the investor becomes

Wt+ -= Nt(Pt+1 + Dt+1) + Bt(1 + rt). (14)
Based on the forecast of excess returns for period t + 2, the portfolio allocation
procedure is repeated at the end of period t + 1. The size of the transaction
costs incurred through the reallocation of funds depends on the composition of
the investor's existing portfolio in bonds (Bt) or in stocks (Nt), and on the
selected portfoliocompositionfor period t + 1. This gives four different cases to
be considered:
Case I (Reinvest Cash Dividends in Shares)
It+,= 1 and It+2= 1,

Nt+ -= Nt + NtDt+1(l - cl)lPt+,
Bt+j= 0.
Case II (Sell Stocks and Buy Bonds)
It,+= 1 and It+2= 0,

Nt+j = 0,
Bt+ = (1 - c2)[(1 - Ci)NtPt+l + NtDt+l].
Case III (Bonds Mature, Buy Shares)
It+,= 0 and It+2= 1,

Nt+j = (1 - cl)Bt(l + rt)/Pt+i,
Bt+j= 0.
Case IV (Bonds Mature, Buy Bonds)

It+= 0 and It+2= 0,
Nt+j = 0,
Bt+= (1 - C2)(1 + rt)Bt.
Using these formulae the value of the investor's funds at the end of period t + 2
becomes
Wt+2 = Nt+1(Pt+2 + Dt+2) + Bt+1(1 + rt+i). (15)
Extension of these rules to subsequent periods is straightforward.

A. Empirical Results from Trading Based on the Recursive Forecasts
Table III presents the trading results for a number of switching portfolios
constructed using forecasts from models selected recursively according to the
different selection strategies. Table III also reports the Sharpe index for
the various portfolios. These computations assume that investors start off with
$100 at the beginning of 1960 and reinvest the portfolio income every month.
In the case of the market and bond portfolios, only the dividends or interests
Table III
Performance Measures for the S&P 500 Switching Portfolio
Relative to the Market Portfolio and T-Bills
(Monthly Results: 1960(1) to 1992(12))
The switching portfolios are based on recursive least squares regressions of excess returns on an
intercept term and a subset of regressors selected from a base set of 9 variables according to
different statistical model selection criteria and financial performancecriteria. See Section II of
the article for a definition of the statistical and financial selection criteria. The hyper-selection
criterion is described in the Appendix. The columns headed Zero, Low, and High refer to the
portfolio returns under the three transaction costs scenarios described in Section III. A of the
article. The final wealth figures assume that investors start off with $100 at the beginning of 1960
and reinvest portfolioincome every month. The recursive wealth procedureuses as a forecasting
model the one that, at each point in time, generated the largest wealth (net of transaction costs)
when its forecasts were used in a simple trading strategy. The recursive Sharpe criterionis based
on a similar procedurewith the only difference that it is now the Sharpe ratio correspondingto
trading results based on the set of predictions generated by a particular regression model that is
being maximized recursively. S.D. is standard deviation.
Panel A: Benchmarks, Statistical Selection Criteria

Market Portfolio Bonds Akaike Schwarz
Transaction
costs Zero Low High Zero Low High Zero Low High Zero Low High
Mean return 11.39 11.34 11.29 5.92 4.66 4.66 14.06 12.51 11.48 11.68 9.46 7.91
S.D. of return 15.71 15.72 15.73 2.61 2.59 2.59 11.16 11.47 11.69 10.73 10.85 10.95
Sharpe'sindex 0.35 0.43 0.42 - - - 0.73 0.69 0.58 0.54 0.44 0.30
Final wealth ($) 2503 2463 2424 660 445 445 6601 4144 3024 3305 1687 1049
Panel B: Statistical Selection Criteria

Hyper-Selection
Sign All Regressors Criterion
Transaction
costs Zero Low High Zero Low High Zero Low High Zero Low High
Mean return 14.83 13.22 12.13 13.69 11.70 10.25 14.46 12.85 11.78 13.58 12.32 11.28
S.D. of return 11.37 11.51 11.58 9.06 9.24 9.40 11.61 11.79 11.91 9.78 10.32 10.77
Sharpe'sindex 0.78 0.74 0.65 0.86 0.76 0.60 0.74 0.70 0.60 0.74 0.74 0.62
Final wealth ($) 8218 5113 3694 6236 3452 2233 7329 4556 3288 5943 4044 2932
Panel C: Financial Criteria
RecursiveWealth Procedure Recursive Sharpe Procedure
Transaction
costs Zero Low High Zero Low High
Mean return 14.00 11.76 10.83 15.14 11.81 10.73
S.D. of return 12.24 11.98 11.22 11.60 10.66 10.97
Sharpe's index 0.66 0.59 0.55 0.79 0.67 0.55
Final wealth ($) 6242 3247 2508 8859 3429 2458
are reinvested on a monthly basis. In contrast, the switching portfolios may

reallocate funds between bonds and shares, depending on whether a change in
the sign of the excess return is predicted.
First consider the results based on zero transaction costs. The mean annual
return on the market index over the period 1960 to 1992 is 11.39 percent,
and is smaller than the mean return on all the switching portfolios under
consideration. Comparing the performance of the switching portfolios based

on forecasts using different model selection criteria, the portfolio based on
Schwarz's criterion only pays a marginally higher mean return than the
buy-and-hold strategy in the market index. At the other end of the perfor-
mance spectrum, the portfolios based on the forecasts using the Akaike, the R2,
and the recursive Sharpe criteria pay mean returns of 14.06, 14.83, and 15.14
percent, respectively, which are substantially above the mean return on the
market index. Interestingly, the annual mean return on the switching portfolio
based on predictions maximizing recursive wealth is smaller than the annual
mean returns on most of the other switching portfolios. Clearly, there are
important differences in the performance of the model selection criteria in
identifying predictability of stock returns. A possible method of resolving the
uncertainty surrounding the choice of model selection criterion is discussed in
the Appendix.
These differences in mean returns are reflected in the end-of-period wealth
accrued to the investment strategies based on reinvesting the funds in either
bonds or shares at the end of every month. Under the zero transaction cost
scenario, the end-of-period funds of the switching portfolios were approxi-
mately twice as large as the end-of-period funds of the market portfolio (in the
case of the Akaike, Sign, and recursive wealth criteria) or three times as large
(in the case of the R2, the recursive Sharpe criterion and the fixed model
specification that includes all regressors). The fact that the recursive predic-
tions based on models selected according to the R2 or the recursive Sharpe
criterion perform better than the recursive predictions from the model that
included all regressors suggests that it may pay off for investors to engage in
an active search process to find an adequate forecasting equation rather than
just basing their forecasts on a fixed model specification that includes the
entire set of regressors.16
Turning next to the standard deviation of the returns on the switching
portfolios, these lie in the range from 9.1 to 12.2 percent per annum, which is
substantially lower than the standard deviation of returns on the market
portfolio (15.7 percent). The standard deviation of the returns on the switching
portfolio selected on the basis of predictions using the sign criterion is partic-
ularly low. Taken together, the higher mean and lower standard deviation of
the returns on the switching portfolios result in high values of the Sharpe ratio
of these portfolios. Notice that the switching portfolio based on recursively
maximizing the Sharpe ratio does not produce the highest Sharpe statistic
among all the switching portfolios.
Allowing for "low" transaction costs of 0.5 of a percent on trading in shares
(c1 = 0.005) and 0.1 of a percent on trading in bonds (c2 =0.001), the mean
payoffs on the switching portfolios decline by between 1.6 and 3.3 percent per
16This should be compared to the findings in Phillips (1992) which report that a model
specification that includes a large number of autoregressive lags, as well as deterministic trends,
tends to produce worse predictions than models selected recursively according to his Bayesian
Posterior Information Criterion.
annum. Thus, under the low transaction cost scenario, mean returns on the
switching portfolios based on predictions from models selected according to
Schwarz's criterion are now lower than the mean returns on the market
portfolio. In comparison, transaction costs hardly affect the mean return on the
buy-and-hold strategy, since the only turnover associated with this portfolio
arises from reinvestment of the dividends. Even so, under this low transaction
cost scenario, the switching portfolios based on the forecasts produced by
models that either included all regressors or were recursively selected accord-
ing to any of the criteria (apart from the Schwarz's criterion) continue to pay
higher mean returns with a lower standard deviation than the market index.
This is the case despite the fact that the number of portfolio switches is
between two and three per year, depending on which set of forecasts is used.
With "high" transaction costs of 1 percent on shares and 0.1 of a percent on
bonds, the mean return on the switching portfolios based on forecasts using the
R2 and the Akaike criteria still exceed the mean return on the market portfolio.
Furthermore, as witnessed by the values of the Sharpe ratios, even with high
transaction costs the switching portfolios based on predictions using these
model selection criteria still offer a better risk-return trade-off than the mar-
ket portfolio. Notice the sharp decline in the performance of the switching
portfolios based on financial criteria as transaction costs are introduced. This
suggests that a two-step procedure using statistical model selection criteria to
compute recursive forecasts of stock returns and then trading on the basis of
these forecasts may be better at identifying predictability in the stock market
than a more direct procedure based on a forecasting model selected according
to a financial criterion.
Using the test statistic suggested by Gibbons, Ross, and Shanken (GRS)
(1989), we computed the joint significance of the intercept terms in regressions
of monthly excess returns of the eight switching portfolios on a constant and
the excess return on the market portfolio. In the case of zero transaction costs
the value of the GRS test statistic was 3.26 (0.001). But as to be expected, the
GRS test statistic declined to 2.36 (0.017) and 1.96 (0.05) for the low and high
transaction cost scenarios, respectively. Rejection probability values are pro-
vided in brackets after the value of the test statistics.17 Clearly, the mean-
variance efficiency of the buy-and-hold strategy is rejected.
We also analyzed the performance of the switching portfolios over the
sub-periods 1960 to 1969, 1970 to 1979 and 1980 to 1989 (see Table IV). For all
three subperiods, the portfolios based on forecasts using the Akaike, R2, or the
sign criteria paid a higher mean return than the buy-and-hold strategy under
the zero transaction cost scenario. The switching portfolios based on the
remaining model selection criteria only paid a higher mean return than the
market during the 1970s and 1980s, while the switching portfolio using the
Schwarz criterion paid a higher mean return than the market index only
during the 1970s. When transaction costs are introduced, it becomes even
17 Under the null hypothesis that the market portfolio is mean-variance efficient the Gibbons,
Ross, and Shanken (1989) test statistic has a central F distribution.

Table IV
Risk and Returns of Different Portfolios for Subperiods:
1960s, 1970s, and 1980s
Zero Low High

Transaction Costs Transaction Costs Transaction Costs
1960 1970 1980 1960 1970 1980 1960 1970 1980
to to to to to to to to to
Risk and Returns 1969 1979 1989 1969 1979 1989 1969 1979 1989
Panel A: Mean (Annualized)
Portfolios
Market 8.63 7.42 18.06 8.56 7.40 18.03 8.49 7.38 18.01
Bond 3.71 6.02 8.23 2.47 4.76 6.94 2.47 4.76 6.94
Akaike 8.78 13.35 19.14 7.37 12.06 17.03 6.55 11.31 15.40
Schwarz 5.20 11.94 16.70 3.28 10.13 14.09 2.09 8.96 12.15
9.17 14.22 20.28 7.45 12.87 18.25 6.31 12.09 16.69
Sign 11.04 11.19 18.37 9.03 9.79 15.55 7.67 8.96 13.31
All regressors 8.13 15.03 19.26 6.29 13.64 17.42 4.99 12.84 16.08
Hyper selection 11.04 11.19 18.53 9.03 9.38 17.17 7.67 7.89 16.71
Recursive wealth proc. 7.81 14.26 18.07 6.90 11.44 15.16 6.28 9.84 14.57
Recursive sharpe proc. 8.49 15.06 21.25 6.61 13.55 13.96 4.28 12.64 13.43
Panel B: Standard Deviation (Annual)
Portfolios
Market 14.36 19.24 12.65 14.39 19.24 12.65 14.42 19.24 12.65
Bond 1.32 1.80 2.66 1.31 1.78 2.63 1.31 1.78 2.63
Akaike 8.30 10.64 12.90 9.16 10.62 13.41 9.72 10.56 13.88
Schwarz 9.92 9.29 10.07 10.53 9.24 10.53 10.97 9.10 11.02
R2 8.99 12.52 10.99 9.70 12.10 11.34 10.20 11.64 11.68
Sign 8.62 7.69 8.94 9.39 7.94 8.78 9.99 8.02 8.75
All regressors 7.14 13.17 12.29 8.37 12.60 12.46 9.36 12.03 12.54
Hyper selection 8.62 7.69 10.81 9.39 9.32 10.79 9.99 8.53 11.67
Panel C: Sharpe Ratio
Portfolios
Market 0.342 0.073 0.776 0.424 0.137 0.877 0.418 0.136 0.875
Bond - - - - - - - - -
Akaike 0.610 0.689 0.846 0.535 0.688 0.752 0.420 0.621 0.609
Schwarz 0.150 0.637 0.842 0.078 0.581 0.679 -0.034 0.461 0.473
R2 0.607 0.655 1.097 0.513 0.670 0.998 0.376 0.630 0.835
Sign 0.849 0.672 1.130 0.699 0.633 0.980 0.521 0.524 0.727
All regressors 0.619 0.683 0.898 0.456 0.705 0.841 0.269 0.672 0.729
Hyper selection 0.849 0.672 0.952 0.699 0.496 0.948 0.521 0.367 0.837
See the notes to Table III for details of the various procedures.
clearer that the higher mean returns on the switching portfolios are concen-
trated in the 1970s. Since the standard deviation of returns in the stock
market was particularly high during the 1970s, these results seem to indicate
that, if ever there was a possibility that investors could improve their market
timing based on a simple forecasting procedure similar to ours, this was during
the volatile periods in the 1970s where macroeconomic risks and volatility in
nominal magnitudes, such as the rate of inflation and nominal interest rates,
mattered the most.
Because the portfolios based on forecasts using models recursively selected
according to the R2, Akaike, and the Sign criteria were quite successful, while
portfolios based on the Schwarz criterion were not as successful in terms of the
values generated for the financial performance measures, it raises the issue of
whether our results can be explained by uncertainty over the choice of model
selection criterion. This problem is addressed in the Appendix, where it is
shown that the switching portfolios continue to strongly outperform the buy-
and-hold strategy, even if the choice of the model selection criterion is made
endogenous to the forecasting and the trading processes. The hyper-selection
procedure advanced in the Appendix for the resolution of the uncertainties
over the choice of model selection criteria and the forecasting model can also be
viewed as an artificial intelligence system capable of detecting unexploited
profit opportunities in the market. Clearly, it would be possible to devise more
comprehensive and sophisticated artificial intelligence systems for the analy-
sis of stock market predictability. However, a comparative analysis of such
systems fall outside the scope of the present paper.
IV. Concluding Remarks and a Discussion of the Main Results

We have proposed in this article a new approach for simulating the behavior
of an investor in real time, using as little hindsight as possible and specifically
accounting for the effect of model specification uncertainty which is crucially
important to any investor trying to forecast asset returns in real time.
As far as the issue of robustness of the predictability of U.S. stock returns is
concerned, our plots of the inclusion frequency of the different factors in the
forecasting models clearly show the importance of allowing for changes in the
underlying process of excess returns in the U.S. stock market that seem to
have taken place during the 1960 to 1992 period. The only variable to be
included in the forecasting models throughout the entire sample period 1960 to
1992 is the one-month lagged value of the one-month T-bill rate. Monetary
growth and industrial production are included in the forecasting models more
or less continuously from the mid and late 1960s, respectively, and the divi-
dend yield variable starts to get included as a regressor in the forecasting
models around 1970. The frequency with which the inflation rate variable and
the 12-month interest rate are included in the forecasting equations is, how-
ever, closely related to economic "regime switches": the inflation rate gets
included after the first oil shock while, according to the models selected by the
R2 criterion, the 12-month interest rate is selected from the mid-seventies

onwards during periods where the Federal Reserve targeted interest rates.
Thus, in general our findings confirm the results of recent research which has
emphasized the importance of predictable components in stock returns related to
the business cycle, (see the references cited in Footnote 1). But we find that
predictability of stock returns of a magnitude that is economically exploitable
seems to depend not just on the evolution of the business cycle, but also on the
magnitude of the shocks. Also there does not seem to be a robust forecasting model
in the sense that the determinants of the predictability of stock returns in the U.S.
seem to have undergone important changes throughout the period under consid-
eration. The timing of the episodes where many of the regressors get included in
the forecasting model seems to be linked to macroeconomic events such as the oil
price shock in 1974 and the Fed's change in its operating procedures during the
1979 to 1982 period. If we are right in our conclusion that important episodes of
predictability of stock returns are closely linked to incidence of sudden shocks to
the economy, then in analyzing stock return predictability it is advisable to use
forecasting procedures that allow for possible regime changes.
Another conclusion emerging from our study is that there appears to be a
relation between periods with high volatility in the markets and periods with
higher-than-normal predictability of excess returns on shares. Our results suggest
that during the relatively calm markets of the 1960s, there were no excess returns
to be gained from following a switching strategy based on forecasts using the
recursively selected regression models. In contrast, during the more volatile 1970s
there seems to have been important gains to be made from following such a
forecasting and trading strategy, while in the 1980s the gains were much smaller.
This finding could be consistent both with incomplete learning in the aftermath of
a large shock to the economy (see Timmermann (1993)) as well as with a story
where the predictability of excess returns is reflecting time-varying risk premia.
In the context of the latter it is, however, difficult to explain why return on the
switching portfolio exceeds the return on the market when the markets are
volatile. It is well known that there is no theoretical reason why required returns
on stocks cannot be lower during periods with relatively high volatility. For
instance, risk averse investors may want to increase their savings, thereby bid-
ding down the equilibrium return on stocks when the markets are particularly
volatile. Furthermore, it is quite possible that the price of risk is time-varying so
that there is no constant, proportional relationship between the first and second
conditional moments of stock returns. Given the existence of a risk-free T-bill rate,
which establishes a lower bound for the nominal return, it seems difficult, how-
ever, in the context of an equilibrium model to explain the predictions of negative
risk premia on the market portfolio apparent in the 1970s.18 On the other hand,
18 One possibility is that, during the periods of high volatility and high inflation in the early
1970s, stocks acted as an inflation hedge making investors more willing to accept low or even
negative expected excess returns of stocks. For a more detailed discussion of the equilibrium
conditionsunder which the predictedexcess return on stocks can be negative in certain states, see
Pesaran and Potter (1993).
it is quite possible that in the event of a majorregime switch in the economy,such

as the one induced by the first oil shock in 1973, learning may take longer than
usual to complete as investors would need extra time to model, say, the new
relationshipbetween inflation, nominal interest rates, and stock returns. Learn-
ing about the market is a continuous process that involves both the routine
updatingof the parameterestimates of a given model as well as searchingfornew
models when there are clear signs that the old established relations are no longer
valid. It is this latter form of learning that is likely to be time consuming, and
seems to accountfor the increased predictabilityof stock returns in periodswith
large and sudden shocks and important regime switches.
Finally, our results do not appear to be sensitive to the particular choice of
trading rule. In fact, we investigated the returns from following a trading rule
that explicitly accounts for the prediction uncertainty. According to this rule,
investors stay in the stock market unless their predictions indicate that there
is at least 90 percent probability that bonds will pay a higher return than
stocks. This is a relatively conservative trading rule in the sense that the
investor stays in the stock market unless he is fairly confident that it will be
better to stay in bonds. Consequently this rule generates fewer switches
between the two types of assets, and transaction costs are much lower. We
foundthat this tradingrule wouldgenerate returns with a higher mean and lower
standard deviationthan the market index, providedtransactioncosts are zero or
low. Under high transactioncosts the mean return on the switching portfoliowas
similar to the market, whereas the volatility of returns was much lower.
Appendix
Uncertainty Over the Choice of Model Selection Criterion-A Profit-Based
Hyper-Selection Criterion
It is clear fromthe empiricalresults reportedin Section III that although most
of the model selection criteria consideredgenerate a profitrelative to the market
index, this is not the case for the Schwarz criterion under the low or high
transaction cost scenarios. Without some rule for choosing a model selection
criterionan investor could not, without the benefit of hindsight, have been guar-
anteed to chooseone of the more successful selection criteria.In this Appendixwe
address this issue and considerthe problemof how an investor could resolve the
uncertainty surroundingthe choice of model selection criterion.
In view of the objective of the exercise we consider a profit-based hyper-
selection criterion that we employ recursively to choose the model selection
criterion to be used subsequently for selecting the forecasting model. The idea
is similar to choosing a subset of regressors from the base set of regressors
explained in detail in Section II. Here, however, there are two levels at which
the search for a suitable forecasting equation needs to be conducted. First, a
model selection criterion needs to be chosen from the base set consisting of the
five statistical model selection criteria, namely the R2, Akaike, Schwarz, and
the Sign criteria, as well as the general model specification that includes all
the regressors. Having chosen a model selection criterion we then proceed to

select the subset of the regressors from the base set for computing one-period
ahead forecasts. More specifically, the profit-based hyper-selection criterion
works as follows: at each point in time we calculate the funds that would have
been generated by using the forecasts from the models selected according to
the various model selection criteria. Then the model selection criterion corre-
sponding to the fund with the highest cumulative wealth is chosen to select the
model to be used for forecasting the excess return for the next period.
In applicationof the hyper-selectionrule we used informationup to 1959(12)to
choosea forecastingmodeland parameterestimates accordingto the five different
ways of selecting a model.Generatingin-sampleforecastsforthe period1954(1)to
1959(12)and using these in a trading strategy beginningin 1954(1),we computed
the value of the funds for the five different portfolios(associated with the five
different model selection criteria) at the end of 1959(12). The model selection
criterionfor which the simulated wealth at this point was highest was then used
to select a model to forecast excess returns for 1960(1). Given the dependenceof
the portfoliovalues on transaction costs, it is clear that the choice of the model
selection criterionwill in general also dependon the assumed level of transaction
costs. In the low transactioncosts scenario,which is likely to be the most relevant
one in practice, the final wealth of the switching portfolio selected using the
profit-basedhyper-selectioncriterionwas 4044 dollars. This compareswith final
funds of 2463 dollarsforthe market index under the low transactioncost scenario.
(See the results for the Hyper-SelectionCriterionin Table III).
In the case of zero transaction costs, the Sign criterion was chosen by the
profit-based hyper-selection criterion from 1960 to 1986. Thereafter, the R2
criterion was chosen up to 1992, apart from a brief spell in 1990, when the
Sign criterion was again chosen. Under the low transaction costs scenario,
the Sign criterion was again chosen by the hyper-selection criterion over the
periods 1960 to 1975 and 1980 to 1985, while the R2 criterion was chosen in
the remaining years. These findings are in accordance with the subsample
results reported in Table IV, which show that the switching portfolio based on
the forecasts using the Sign criterion paid the highest return during the 1960s,
but did less well relative to other selection criteria during the 1970s and 1980s.
REFERENCES
Akaike, H., 1973, Informationtheory and an extension of the maximum likelihood principle, in
B.N. Petrov and F. Csaki, Eds., Second International Symposium on Information Theory,
Akademiai Kiado, (Budapest, Hungary), 267-281.
Amemiya, T., 1980, Selection of regressors, International EconomicReview 21, 331-345.
Angas, L.L.B., 1936, Investment for appreciation. Forecasting movements in security prices.
Technique of Trading in Shares for Profit (Macmillan, London).
Balvers, R.J., T.F. Cosimano, and B. McDonald, 1990, Predicting stock returns in an efficient
market, Journal of Finance 45, 1109-1128.
Bossaerts, P., and P. Hillion, 1994, Implementing statistical criteria to select return forecasting
models, Workingpaper, Caltech.
Breen, W., L.R. Glosten, and R. Jagannathan, 1990, Predictablevariations in stock index returns,
Journal of Finance 44, 1177-1189.
Campbell,J.Y., 1987, Stock returns and the term structure, Journal of Financial Economics 18,
373-399.
Cochrane, J.H., 1991, Production-basedasset pricing and the link between stock returns and
economicfluctuations, Journal of Finance 46, 209-238.
Dowrie, G.W. and D.R. Fuller, 1950, Investments (second ed.). (John Wiley, New York).
Fama, E.F., 1991, Efficient capital markets: II, Journal of Finance 46, 1575-1617.
Fama, E.F., and K.R.French, 1989, Business conditionsand expectedreturns on stocks and bonds,
Journal of Financial Economics 25, 23-49.
Ferson, W.E., and C.R. Harvey, 1993, The risk and predictabilityof international equity returns,
Review of Financial Studies 6, 527-566.
French, K.R., G.S. Schwert, and R.F. Stambaugh, 1987, Expected stock returns and volatility,
Journal of Financial Economics 19, 3-30.
Gibbons, M.R., S.A. Ross, and J. Shanken, 1989, A test of the efficiency of a given portfolio,
Econometrica 57, 1121-1152.
Glosten, C.R.,R. Jagannathan, and D.E. Runkle, 1993, On the relation between the expectedvalue
and the volatility of the nominal excess returns on stocks, Journal of Finance 48, 1779-1802.
Goetzmann,W.N., and P. Jorion, 1993, Testing the predictivepower of dividendyields, Journal of
Finance 48, 663-680.
Henriksson, R.D., and R.C. Merton, 1981, On market timing and investment performance.
II. Statistical proceduresfor evaluating forecasting skills, Journal of Business 54, 513-533.
Jensen, M.C., 1978, Some anomalous evidence regarding market efficiency,Journal of Financial
Economics 6, 95-101.
Leitch, G., and J.E. Tanner, 1991, Economicforecast evaluation: Profits versus the conventional
error measures, American Economic Review 81, 580-590.
Mallows, C.P., 1973, Some comments on Cp, Technometrics15, 661-675.
Mishkin, F.S., 1992, The economics of money, banking, and financial markets, Third ed. (Harper
Collins Publishers, New York).
Morgan,E.V., and W.A.Thomas, 1962, The stock exchange. Its history and functions, (Elek Books,
London).
Nelson, C.R., and M.J. Kim, 1993, Predictable stock returns: The role of small sample bias,
Journal of Finance 48, 641-662.
Pesaran, M.H., and S. Potter, 1993, Equilibriumasset pricing models and predictabilityof excess
returns, Department of Applied Economics,Workingpaper, CambridgeUniversity.
Pesaran, M.H., and A. Timmermann, 1992, A simple nonparametric test of predictive perfor-
mance, Journal of Business and Economic Statistics 10, 461-465.
Pesaran, M.H., and A. Timmermann, 1994a, Forecasting stock returns. An examination of stock
market trading in the presence of transaction costs, Journal of Forecasting 13, 335-367.
Pesaran, M.H., and A. Timmermann, 1994b, A generalisation of the nonparametricHenriksson-
Merton test of market timing, Economics Letters 44, 1-7.
Pesaran, M.H., and A. Timmermann, 1994c, The use of recursive model selection strategies in
forecasting stock returns, Department of Applied Economics,University of Cambridge,Work-
ing paper No. 9406.
Phillips, P.C.B., 1992, Bayesian model selection and prediction with empirical applications.
Cowles Foundation Discussion Paper No. 1023, Yale University.
Phillips, P.C.B., and Ploberger, 1994, Posterior odds testing for a unit root with data-based model
selection, Econometric Theory 10, 744-808.
Potscher, B.M., 1991, Effects of model selection on inference, EconometricTheory7, 163-185.
Prime, J.H., 1946, Investment analysis (Prentice Hall, New York).
Rose, H.B., 1960, The economicbackgroundto investment (CambridgeUniversity Press).
Schwarz, G., 1978, Estimating the dimension of a model, Annals of Statistics 6, 461-464.
Shibata, R., 1976, Selection of the order of an autoregressive model by Akaike's information
criterion,Biometrika 63, 117-126.
Theil, H., 1958, Economicforecasts and policy, (Amsterdam,North Holland).
Timmermann,A., 1993, How learning in financial markets generates excess volatility and pre-
dictability in stock prices, Quarterly Journal of Economics, 108, 1135-1145.

Perasan & Timmermann - Predictability of Stock Returns, Robustness and Economic Significance.

Uploaded by

Copyright:

Available Formats

Perasan & Timmermann - Predictability of Stock Returns, Robustness and Economic Significance.

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Perasan & Timmermann - Predictability of Stock Returns, Robustness and Economic Significance.

Uploaded by

Copyright:

Available Formats

American Finance Association

Predictability of Stock Returns: Robustness and Economic Significance

Predictability of Stock Returns:

MANY RECENTSTUDIESCONCLUDE that stock returns can be predicted by means of

interpreted only in conjunction with, and in relation to, an intertemporal

I. Identifying Predictability of Stock Returns:

2 A similarrecursivemodellingstrategyhas also been consideredby Phillips(1992)and Phillipsand

where XTi is a (Ki + 1) X 1 vector of regressors under model Mi, obtained as

for t =K+ 2,K+ 3,...,)T, 2

to compute the forecasts. Prominent examples are Mallows'(1973) Cpcriterion,Amemiya's(1980)

criteria are likelihood-based and assign different weights to the "parsimony"

tO E (PT+1 -XT,'i~i)2It (4)

The Akaike and Schwarz model selection criteria can be written as

AICtj = LLtj - (Ki + 1), (5)

BICt i= LLt - 1/2(Ki + 1)log(t). (6)

The R2 criterion, originally suggested by Theil (1958) as a criterion for select-

where &t~is the unbiased estimator of a2 given by &t2= (P+? -

TCt i= LLt i- 1/2 log t - ki - 1 (8)

where rTi is the period T return (net of transaction costs) on portfolio i,

weak assumptions about the underlying data generating process (DGP). We do

II. Recursive Predictions of U.S. Stock Returns

As the previous sectionmakes

gies, 1960(1)to 1992(12). . l~"l, 19 'l I'19. 91 W1Il #1 97 ''

ovet 1a965912) to5 99 9(1 eri15

allgthe d.Returaio e s ltentimtovie

plays o the manott resulvts. atit bevto

4o.1t63 -6 -l 1,L;l -3 s tv I5' .1 "83I" 98 BS'. 16, M 11~91,I.AI

Figure 2. Shwtestandard errors of recursive excessrqainnelegrnaiessionsl

m-etbre-cusiey Ob--U co sr n ff Obe-tweei-n

.,_ SP-;_1X,M. T--' 8; t i I

fr, ? IOCX a -8 1st 5 s, 06SS 1B7as 090Bmaue 101 1973

again startsMtohelin steailyup

soreckmart in easured si g nificantl around1.9, ,th predi ,b it, of stoc

Forichs wher thevariabets inrte beaseivetlyunettled Table

models. As to be expected, on balance the R2 and the Akaike criteria tend to

Figure4;.dIncluso frequeny of th variablesin~

seecio cr3'iterIonie190 " 1)t '1992(12). 97 incusoof. 'the variable in

obsrvepred" 1of stock retrn.

that can be used to detect nonstationarities in the underlying data generating

C. The Market Timing Value of The Recursive Forecasts

III. Assessing the Economic Significance of Predictability of

metric Henriksson-Mertontest statistic reported in Table II was 0.03.

1960 to 1992 1960 to 1969 1970 to 1979 1980 to 1989

* Indicates statistically significant evidence of market timing at the 10 percent level.

information, that is capable of yielding positive excess profits (discounted at an

considerably more leptokurtic than, say, the normal distribution. Standard

Bt= Wt(1 - It+1 - c2). (13)

For period t + 1, the budget constraint of the investor becomes

It+,= 1 and It+2= 1,

Case II (Sell Stocks and Buy Bonds)

It,+= 1 and It+2= 0,

Case III (Bonds Mature, Buy Shares)

It+,= 0 and It+2= 1,

Case IV (Bonds Mature, Buy Bonds)

Extension of these rules to subsequent periods is straightforward.

Panel A: Benchmarks, Statistical Selection Criteria

Panel B: Statistical Selection Criteria

are reinvested on a monthly basis. In contrast, the switching portfolios may

consideration. Comparing the performance of the switching portfolios based

Ross, and Shanken (1989) test statistic has a central F distribution.