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Forecasting stock market returns by summing the frequency-decomposed parts

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  • Faria, Gonçalo
  • Verona, Fabio

Abstract

We generalize the Ferreira and Santa-Clara (2011) sum-of-the-parts method for forecasting stock market returns. Rather than summing the parts of stock returns, we suggest summing some of the frequency-decomposed parts. The proposed method significantly improves upon the original sum-of-the-parts and delivers statistically and economically gains over historical mean forecasts, with monthly out-of-sample R2 of 2.60% and annual utility gains of 558 basis points. The strong performance of this method comes from its ability to isolate the frequencies of the parts with the highest predictive power, and from the fact that the selected frequency-decomposed parts carry complementary information that captures different frequencies of stock market returns.

Suggested Citation

  • Faria, Gonçalo & Verona, Fabio, 2018. "Forecasting stock market returns by summing the frequency-decomposed parts," Journal of Empirical Finance, Elsevier, vol. 45(C), pages 228-242.
  • Handle: RePEc:eee:empfin:v:45:y:2018:i:c:p:228-242
    DOI: 10.1016/j.jempfin.2017.11.009
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    More about this item

    Keywords

    Predictability; Stock returns; Equity premium; Asset allocation; Frequency domain; Wavelets;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • 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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