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Industry equi-correlation: A powerful predictor of stock returns

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  • Wang, Yudong
  • Pan, Zhiyuan
  • Wu, Chongfeng
  • Wu, Wenfeng

Abstract

We show that the detrended equi-correlation of the returns of industry portfolios is a strong predictor of excess returns to the S&P 500 Index. Using a sample from 1927 to 2015, our monthly industry equi-correlation (IEC) index produces an out-of-sample R2 of as high as 0.888%. For an investor with mean–variance utility, the IEC index can generate utility gains of 120.5 basis points over the benchmark model of the historical average. The return predictability of the IEC index is stronger than that of all of the popular predictor variables. Furthermore, we find that incorporating IEC in a univariate predictive regression with a popular predictor can significantly improve the out-of-sample forecasting performance of the individual models and their forecast combinations. These findings are confirmed by a large battery of robustness checks.

Suggested Citation

  • Wang, Yudong & Pan, Zhiyuan & Wu, Chongfeng & Wu, Wenfeng, 2020. "Industry equi-correlation: A powerful predictor of stock returns," Journal of Empirical Finance, Elsevier, vol. 59(C), pages 1-24.
    • Handle: RePEc:eee:empfin:v:59:y:2020:i:c:p:1-24
    DOI: 10.1016/j.jempfin.2020.07.005
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    More about this item

    Keywords

    Stock excess return; Predictive regression; Industry portfolio; Dynamic equi-correlation; Popular predictor variables;
    All these keywords.

    JEL classification:

    • C11 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Bayesian Analysis: General
    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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