Non‐linear Predictability of Value and Growth Stocks and Economic Activity

Recent empirical evidence suggests that stock market index returns are predictable from a variety of financial and macroeconomic variables. We extend this research by examining value and growth portfolios constructed by book‐to‐market ratio, and consider whether such predictability is evident here. Further, we assess whether such predictability is better characterised by a non‐linear form and whether such non‐linear predictability can be exploited to provide superior forecasts to those obtained from a linear model. General non‐linearities are examined using non‐parametric techniques, which suggest possible threshold behaviour. This leads to estimation of a smooth‐transition threshold model, with the results indicating an improved in‐sample performance and marginally superior out‐of‐sample forecast results.