Predictability of Stock Returns: Robustness and Economic Significance

Authors

  • M. HASHEM PESARAN,

  • ALLAN TIMMERMANN

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    • Pesaran is from Trinity College, Cambridge. Timmermann is from University of California, San Diego. This is a substantially revised and abridged version of the paper “The Use of Recursive Model Selection Strategies in Forecasting Stock Returns,” Department of Applied Economics Working paper No. 9406, March 1994, University of Cambridge. We would like to thank a referee and the editor, René 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 California at San Diego for helpful comments on the earlier version. The first author gratefully acknowledges financial support from the Economic and Social Research Council and the Newton Trust of Trinity College, Cambridge.


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-hold strategy in the market index. We find that the predictive power of various economic factors over stock returns changes through time and tends to vary with the volatility of returns. The degree to which stock returns were predictable seemed 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.

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