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Explaining future market return and evaluating market condition with common preferred spread index

Changju Lee, Seungmo Ku, Poongjin Cho and Woojin Chang

Physica A: Statistical Mechanics and its Applications, 2019, vol. 525, issue C, 921-934

Abstract: We build CPS-index (Common Preferred Spread Index) using the spread return between common and preferred stock pairs, and show that CPS-index has explanatory power for long term market return. Common stocks are more sensitive to the market condition than preferred stocks so that CPS-index tends to oscillate according to market condition. We observe that the future realized market return becomes high when CPS-index is low and vice versa. There is an inverse relationship between CPS-index and the future market return of S&P500 index. The statistical analysis of the regression between CPS-index and future market return shows that CPS-index has a significant power to explain the future realized market return in 21 months or up to 48 months ahead of time. Multivariate regression analysis confirms that the inclusion of CPS-index as an explanatory variable enhances the market predictability. We apply neural network to predict the future market return and observe that CPS-index provides better prediction results in any time horizon longer than twenty seven months.

Keywords: Stock market index; Preferred stock; Pairs trading; Return spread; Prediction (search for similar items in EconPapers)
Date: 2019
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Handle: RePEc:eee:phsmap:v:525:y:2019:i:c:p:921-934