Modeling stock index returns by means of partial least-squares methods: An out-of-sample analysis for three stock markets

Authors

  • Cetin-Behzet Cengiz,

    Corresponding author
    1. Chair of Decision Theory and Financial Services, RWTH-Aachen University, Templergraben 56, Aachen, Germany
    • Chair of Decision Theory and Financial Services, RWTH-Aachen University, Templergraben 56, Aachen, Germany
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  • Helmut Herwartz

    1. Institute for Statistics and Econometrics, Christian-Albrechts-University of Kiel, Olshausenstr. 40-60 Kiel, Germany
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Abstract

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.

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