Macroeconomic Factors and Equity Premium Predictability

Daniel Buncic and Martin Tischhauser

No 1522, Economics Working Paper Series from University of St. Gallen, School of Economics and Political Science

Abstract: Neely et al. (2014) have recently demonstrated how to efficiently combine information from a set of popular technical indicators together with the standard Goyal andWelch (2008) predictor variables widely used in the equity premium forecasting literature to improve outof- sample forecasts of the equity premium using a small number of principal components. We show that forecasts of the equity premium can be further improved by, first, incorporating broader macroeconomic data into the information set, second, improving the selection of the most relevant factors and combining the most relevant factors by means of a forecast combination regression, and third, imposing theoretically motivated positivity constraints on the forecasts of the equity premium. Applying standard out-of-sample forecast evaluation tests, we find that in particular our proposed forecast combination approach, which combines forecasts of the most relevant Neely et al. (2014) and macroeconomic factors and further imposes positivity constraints on the equity premium forecasts, generates statistically significant and economically sizable improvements over the best performing model of Neely et al. (2014). Out-of-sample R2 values can be as high as 1.75%, with (annualised) gains in certainty equivalent returns of up to 3.35%, relative to the ALL factors forecasts of Neely et al. (2014).

Keywords: Equity premium predictability; Factor models; Macroeconomic variables; Adaptive Lasso; Sign restrictions; Forecast combination; Asset allocation (search for similar items in EconPapers)
JEL-codes: C53 E44 G12 G17 (search for similar items in EconPapers)
Pages: 48 pages
Date: 2015-10
New Economics Papers: this item is included in nep-for and nep-mac
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Journal Article: Macroeconomic factors and equity premium predictability (2017)
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Persistent link: https://EconPapers.repec.org/RePEc:usg:econwp:2015:22

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