The predictive ability of stock market factors

Mohammed Mohammed Elgammal, Fatma Ehab Ahmed and David Gordon McMillan

Studies in Economics and Finance, 2021, vol. 39, issue 1, 111-124

Abstract: Purpose - This paper aims to ask whether a range of stock market factors contain information that is useful to investors by generating a trading rule based on one-step-ahead forecasts from rolling and recursive regressions. Design/methodology/approach - Using USA data across 3,256 firms, the authors estimate stock returns on a range of factors using both fixed-effects panel and individual regressions. The authors use rolling and recursive approaches to generate time-varying coefficients. Subsequently, the authors generate one-step-ahead forecasts for expected returns, simulate a trading strategy and compare its performance with realised returns. Findings - Results from the panel and individual firm regressions show that an extended Fama-French five-factor model that includes momentum, reversal and quality factors outperform other models. Moreover, rolling based regressions outperform recursive ones in forecasting returns. Research limitations/implications - The results support notable time-variation in the coefficients on each factor, whilst suggesting that more distant observations, inherent in recursive regressions, do not improve predictive power over more recent observations. Results support the ability of market factors to improve forecast performance over a buy-and-hold strategy. Practical implications - The results presented here will be of interest to both academics in understanding the dynamics of expected stock returns and investors who seek to improve portfolio performance through highlighting which factors determine stock return movement. Originality/value - The authors investigate the ability of risk factors to provide accurate forecasts and thus have economic value to investors. The authors conducted a series of moving and expanding window regressions to trace the dynamic movements of the stock returns average response to explanatory factors. The authors use the time-varying parameters to generate one-step-ahead forecasts of expected returns and simulate a trading strategy.

Keywords: Panel data; Stock returns; Predictability; Risk factors; Trading rule; Stock market factors; Panel; C22; G12 (search for similar items in EconPapers)
Date: 2021
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Persistent link: https://EconPapers.repec.org/RePEc:eme:sefpps:sef-01-2021-0010

DOI: 10.1108/SEF-01-2021-0010

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