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Debt-by-Price Ratio, End-of-Year Economic Growth, and Long-Term Prediction of Stock Returns

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  • Parastoo Mousavi

    (Faculty of Actuarial Science and Insurance, Cass Business School, City, University of London, 106 Bunhill Row, London EC1Y 8TZ, UK)

Abstract

With the prominent role of government debt in economic growth in recent decades, one would expect that government debt alongside economic growth to be a risk factor priced in the time series of stock returns. In this paper, this idea is investigated by applying a nonparametric model, namely, a local-linear kernel smoother with the aim of forecasting long-term stock returns where the model and smoothing parameters are chosen by cross-validation. While a wide range of predictive variables are examined, we find that our newly introduced debt-by-price ratio and the third to fourth quarter economic growth are robust predictors of stock returns, beating the well-known predictive variables in the literature by a significant difference. The combination of these two covariates can explain almost 30% variation of stock returns at a one-year horizon. This is very crucial considering the difficulty in capturing even a small proportion of movements in stock returns.

Suggested Citation

  • Parastoo Mousavi, 2021. "Debt-by-Price Ratio, End-of-Year Economic Growth, and Long-Term Prediction of Stock Returns," Mathematics, MDPI, vol. 9(13), pages 1-18, July.
  • Handle: RePEc:gam:jmathe:v:9:y:2021:i:13:p:1550-:d:586965
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