Out‐of‐sample equity premium prediction: A scenario analysis approach

We propose two methods of equity premium prediction with single and multiple predictors respectively and evaluate their out‐of‐sample performance using US stock data with 15 popular predictors for equity premium prediction. The first method defines three scenarios in terms of the expected returns under the scenarios and assumes a Markov chain governing the occurrence of the scenarios over time. It employs predictive quantile regressions of excess return on a predictor for three quantiles to estimate the occurrence of the scenarios over an in‐sample period and the transition probabilities of the Markov chain, predicts the expected returns under the scenarios, and generates an equity premium forecast by combining the predicted expected returns under three scenarios with the estimated transition probabilities. The second method generates an equity premium forecast by combining the individual forecasts from the first method across all predictors. For most of predictors, the first method outperforms the benchmark method of historical average and the traditional predictive linear regression with a single predictor both statistically and economically, and the second method consistently performs better than several competing methods used in the literature. The performance of our methods is further examined under different scenarios and economic conditions, and is robust for two different out‐of‐sample periods and specifications of the scenarios.