Pockets of Predictability
Leland Farmer (),
Lawrence Schmidt and
Allan G Timmermann
No 12885, CEPR Discussion Papers from C.E.P.R. Discussion Papers
Return predictability in the U.S. stock market is local in time as short periods with significant predictability (`pockets') are interspersed with long periods with little or no evidence of return predictability. We document this empirically using a flexible non-parametric approach and explore possible explanations of this finding, including time-varying risk premia. We find that short-lived predictability pockets are inconsistent with a broad class of affine asset pricing models. Conversely, pockets of return predictability are more in line with a model with investors' incomplete learning about a highly persistent growth component in the underlying cash flow process which undergoes occasional regime shifts.
Keywords: affine asset pricing models; cash flows; incomplete learning; Markov switching predictive systems; Predictability of stock returns (search for similar items in EconPapers)
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