Equity premium prediction and the state of the economy

Ilias Tsiakas, Jiahan Li and Haibin Zhang

Journal of Empirical Finance, 2020, vol. 58, issue C, 75-95

Abstract: We detect cyclical variation in the predictive information of economic fundamentals, which can be used to substantially improve and simplify out-of-sample equity premium prediction. Economic fundamentals based on stock-specific information (notably the dividend yield) deliver better predictions in expansions. Economic fundamentals based on aggregate information (notably the short rate) deliver better predictions in recessions. Accordingly, a simple forecast combination of one predictor that generates cyclical forecasts and one predictor that generates countercyclical forecasts can deliver statistically significant and economically valuable equity premium predictions in both expansions and recessions. A prominent two-predictor forecast combination that performs well is the dividend yield and the short rate. Strategies designed for ex-ante timing of the business cycle can provide additional economic gains in equity premium prediction.

Keywords: Equity premium; Out-of-sample prediction; Economic fundamentals; Business cycle; Financial cycle; Diversification (search for similar items in EconPapers)
JEL-codes: G11 G14 G17 (search for similar items in EconPapers)
Date: 2020
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Citations: View citations in EconPapers (11)

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Working Paper: Equity Premium Prediction and the State of the Economy (2020)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:empfin:v:58:y:2020:i:c:p:75-95

DOI: 10.1016/j.jempfin.2020.05.004

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