The role of categorical EPU indices in predicting stock-market returns

Juan Chen, Feng Ma, Xuemei Qiu and Tao Li

International Review of Economics & Finance, 2023, vol. 87, issue C, 365-378

Abstract: This study investigates the predictive ability of categorical economic-policy uncertainty (EPU) indices for stock-market returns. The results indicate that some categorical EPU indices have superior predictive ability for stock returns and even achieve higher realized utility than the original EPU index and popular predictors. Furthermore, the diffusion indices based on EPU categories, especially those that use partial least squares (PLS) to extract the principal components, more effectively use the forecast information contained in categorical EPU indices, resulting in improved forecast performance, including reduced forecast errors and increased economic value for investors. In addition, the categorical EPU indices show superior forecasting performance during economic-expansion, the China-US trade-war, and COVID-19 pandemic periods.

Keywords: EPU index; Categorical EPU index; Stock return predictability; Dimension reduction approach; Forecast combination (search for similar items in EconPapers)
Date: 2023
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Citations: View citations in EconPapers (2)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:reveco:v:87:y:2023:i:c:p:365-378

DOI: 10.1016/j.iref.2023.05.003

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