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Equity Premium Prediction and the State of the Economy

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  • Ilias Tsiakas

    (Department of Economics and Finance, University of Guelph, Canada; Rimini Centre for Economic Analysis)

  • Jiahan Li

    (GMO LLC)

  • Haibin Zhang

    (University of Guelph, Canada)

Abstract

We detect cyclical variation in the predictive information of economic fundamentals, which can be used to substantially improve and simplify out-of-sample equity premium prediction. Economic fundamentals based on stock-specific information (notably the dividend yield) deliver better predictions in expansions. Economic fundamentals based on aggregate information (notably the short rate) deliver better predictions in recessions. Accordingly, a simple forecast combination of one predictor that generates cyclical forecasts and one predictor that generates countercyclical forecasts can deliver statistically significant and economically valuable equity premium predictions in both expansions and recessions. A prominent two-predictor forecast combination that performs well is the dividend yield and the short rate. Strategies designed for ex-ante timing of the business cycle can provide additional economic gains in equity premium prediction.

Suggested Citation

  • Ilias Tsiakas & Jiahan Li & Haibin Zhang, 2020. "Equity Premium Prediction and the State of the Economy," Working Paper series 20-16, Rimini Centre for Economic Analysis.
    • Handle: RePEc:rim:rimwps:20-16
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    Keywords

    Equity Premium; Out-of-Sample Prediction; Economic Fundamentals; Business Cycle; Financial Cycle; Diversification;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation

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