Interest rate level and stock return predictability

We employ a novel interest rate‐determined model‐switching strategy to forecast stock returns and find persistent predictive ability among a number of economic fundamentals. This strategy switches predictive models based on whether a real‐time interest rate is higher than the mean level interest rate of a look‐back period. The robustly better predictive ability of the new strategy relative to the original OLS regressions suggests that stock returns react more rationally to the variation in economic fundamentals if the contemporaneous interest rates are high. This pattern is consistent with prior literature demonstrating that a high interest rate attenuates speculative demand (Keynes, The general theory of employment, interest, and money, Harcourt Brace, London, 1936), while speculative trading drives stock prices away from their valuation founded on economic fundamentals (Scheinkman & Xiong, Journal of Political Economy, 111, 1183, 2003).