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Forecasting Stock Market Returns: The Sum of the Parts is More than the Whole

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Author Info
Miguel A. Ferreira
Pedro Santa-Clara
Abstract

We propose forecasting separately the three components of stock market returns: dividend yield, earnings growth, and price-earnings ratio growth. We obtain out-of-sample R-square coefficients (relative to the historical mean) of nearly 1.6% with monthly data and 16.7% with yearly data using the most common predictors suggested in the literature. This compares with typically negative R-squares obtained in a similar experiment by Goyal and Welch (2008). An investor who timed the market with our approach would have had a certainty equivalent gain of as much as 2.3% per year and a Sharpe ratio 77% higher relative to the historical mean. We conclude that there is substantial predictability in equity returns and that it would have been possible to time the market in real time.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 14571.

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Date of creation: Dec 2008
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Handle: RePEc:nbr:nberwo:14571

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G1 - Financial Economics - - General Financial Markets
G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting

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