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Earnings forecasts and the predictability of stock returns: evidence from trading the S&P

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  • Joel Lander
  • Athanasios Orphanides
  • Martha Douvogiannis

Abstract

We develop a simple error-correction model, based on a well-known theory, espoused by Benjamin Graham and David Dodd and others, which presumes stock returns tend to restore an equilibrium relationship between the forecasted earnings yield on common stocks and the yield on bonds. The estimation uses I/B/E/S analysts forecasts of S&P earnings. To evaluate the model, we use rolling regressions to obtain out-of-sample forecasts of excess returns. Tests of association show the implicit timing signals to be statistically significant. Further, a strategy of investing in cash, when the excess return forecast is negative, and investing in the S&P, when the excess return forecast is positive, outperforms the S&P with higher returns and smaller volatility. Using the bootstrap methodology, we demonstrate that the findings are statistically significant.

Suggested Citation

  • Joel Lander & Athanasios Orphanides & Martha Douvogiannis, 1997. "Earnings forecasts and the predictability of stock returns: evidence from trading the S&P," Finance and Economics Discussion Series 1997-6, Board of Governors of the Federal Reserve System (U.S.).
  • Handle: RePEc:fip:fedgfe:1997-6
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    References listed on IDEAS

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    Cited by:

    1. De Santis, Roberto A. & Favero, Carlo A. & Roffia, Barbara, 2013. "Euro area money demand and international portfolio allocation: A contribution to assessing risks to price stability," Journal of International Money and Finance, Elsevier, vol. 32(C), pages 377-404.
    2. Koutmos, Dimitrios, 2012. "An intertemporal capital asset pricing model with heterogeneous expectations," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 22(5), pages 1176-1187.
    3. Carlo A. Favero & Arie E. Gozluklu & Haoxi Yang, 2016. "Demographics and the Behavior of Interest Rates," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 64(4), pages 732-776, November.
    4. Alain Durré & Pierre Giot, 2007. "An International Analysis of Earnings, Stock Prices and Bond Yields," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 34(3-4), pages 613-641.
    5. Pu Shen, 2002. "Market timing strategies that worked," Research Working Paper RWP 02-01, Federal Reserve Bank of Kansas City.
    6. Roberto Santis, 2015. "Quantity theory is alive: the role of international portfolio shifts," Empirical Economics, Springer, vol. 49(4), pages 1401-1430, December.
    7. Tom Roberts, 2017. "A Counterfactual Valuation of the Stock Index as a Predictor of Crashes," Staff Working Papers 17-38, Bank of Canada.
    8. Eduardo Walker, 1998. "Mercado Accionario y Crecimiento Económico en Chile," Latin American Journal of Economics-formerly Cuadernos de Economía, Instituto de Economía. Pontificia Universidad Católica de Chile., vol. 35(104), pages 49-72.
    9. Marco Aiolfi & Carlo Ambrogio Favero, "undated". "Model Uncertainty, Thick Modelling and the predictability of Stock Returns," Working Papers 221, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
    10. Giot, Pierre & Petitjean, Mikael, 2007. "The information content of the Bond-Equity Yield Ratio: Better than a random walk?," International Journal of Forecasting, Elsevier, vol. 23(2), pages 289-305.
    11. Stein, Michael & Islami, Mevlud & Lindemann, Jens, 2012. "Identifying time variability in stock and interest rate dependence," Discussion Papers 24/2012, Deutsche Bundesbank.
    12. Christophe, Faugere, 2003. "A Required Yield Theory of Stock Market Valuation and Treasury Yield Determination," MPRA Paper 15579, University Library of Munich, Germany, revised 04 Jun 2009.
    13. : Arie E. Gozluklu, 2012. "Inflation, Stock Market and Long-Term Investors: Real Effects of Changing Demographics," Working Papers wpn12-06, Warwick Business School, Finance Group.
    14. repec:rss:jnljfe:v3i2p4 is not listed on IDEAS
    15. Bonfiglioli, Alessandra & Favero, Carlo A., 2005. "Explaining co-movements between stock markets: The case of US and Germany," Journal of International Money and Finance, Elsevier, vol. 24(8), pages 1299-1316, December.
    16. Christophe Faugere & Julian Van Erlach, 2003. "A General Theory of Stock Market Valuation and Return," Finance 0311005, University Library of Munich, Germany, revised 17 May 2004.
    17. Terenzio Cozzi, 2005. "A reappraisal of Modigliani's finance theories," BNL Quarterly Review, Banca Nazionale del Lavoro, vol. 58(233-234), pages 215-235.
    18. :Carol A. Favero & Arie E. Gozluklu & Andrea Tamoni, 2009. "Long-Run Factors and Fluctuations in Dividend/Price," Working Papers wpn09-04, Warwick Business School, Finance Group.
    19. Terenzio Cozzi, 2005. "Una rivisitazione delle teorie di Modigliani sulla finanza," Moneta e Credito, Economia civile, vol. 58(230-231), pages 233-254.
    20. Terenzio Cozzi, 2005. "A reappraisal of Modigliani's finance theories," Banca Nazionale del Lavoro Quarterly Review, Banca Nazionale del Lavoro, vol. 58(233-234), pages 215-235.

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    Keywords

    Forecasting ; Stocks;

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