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Equity premium prediction: The role of economic and statistical constraints

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  • Li, Jiahan
  • Tsiakas, Ilias

Abstract

In this paper, we show that the equity premium is predictable out-of-sample when we use a predictive regression that conditions on a large set of economic fundamentals, subject to: (1) economic constraints on the sign of coefficients and return forecasts, and (2) statistical constraints imposed by shrinkage estimation. Equity premium predictability delivers a certainty equivalent return of about 2.7% per year over the benchmark for a mean–variance investor. Our predictive framework outperforms a large group of competing models that also condition on economic fundamentals, as well as models that condition on technical indicators.

Suggested Citation

  • Li, Jiahan & Tsiakas, Ilias, 2017. "Equity premium prediction: The role of economic and statistical constraints," Journal of Financial Markets, Elsevier, vol. 36(C), pages 56-75.
    • Handle: RePEc:eee:finmar:v:36:y:2017:i:c:p:56-75
    DOI: 10.1016/j.finmar.2016.09.001
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    More about this item

    Keywords

    Equity premium; Out-of-sample prediction; Economic fundamentals; Technical indicators; Shrinkage estimation;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation

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