• return predictability;
  • partial least-squares;
  • out-of-sample prediction;
  • dynamic factor model;
  • trading rules

We analyze the underlying economic forces of the stock markets in Germany, the U.K. and the U.S. Identifying a number of variables evincing return predictability, we follow a partial least-squares (PLS) approach to combine these observables into a few latent factors. Conditional on European markets, our findings indicate (i) superior prediction performance of PLS-based schemes in comparison with both, a random walk and a first-order autoregressive benchmark model, (ii) consistent profitable trading on the German and British market, (iii) profitable linear forecast combinations, (iv) the U.S. stock market is diagnosed as informationally efficient. Copyright © 2010 John Wiley & Sons, Ltd.