Does Debt Ceiling and Government Shutdown Help in Forecasting the US Equity Risk Premium?

This article evaluates the predictability of the equity risk premium in the United States by comparing the individual and complementary predictive power of macroeconomic variables which are popular in academia and technical indicators which are widely used by practitioners in the market using a comprehensive set of 16 economic and 14 technical predictors over a monthly out-of-sample period of 1995:1 to 2012:12 and an in-sample period of 1986:1-1994:12. In order to do so we consider, in addition to the set of variables used in Neely et al. (2013), the forecasting ability of two other important variables namely government shutdown and debt ceiling. Using a more recent dataset compared to that of Neely et al. (2013), our results tend to support the better out-of-sample predictive ability of technical indicators when compared to economic variable but to a lesser extent. Our results also show that one of the newly added variables namely government shutdown provides statistically significant out-of-sample predictive power over the equity risk premium relative to the historical average based on the MSFE-adjusted statistics. An important finding however is that, during recessions, the majority of our indicators including the newly added government shutdown variable can provide better out-of-sample predictive power when compared to the historical benchmark. Most of the variables, including government shutdown but not debt ceiling, also show significant economic gains for a risk averse investor especially during recessions which can be interpreted as a willingness to pay a portfolio management fee.