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Predicting stock returns with implied cost of capital: A partial least squares approach

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  • Hoang, Khoa
  • Cannavan, Damien
  • Huang, Ronghong
  • Peng, Xiaowen

Abstract

We extract a single factor from popular aggregate implied cost of capital (ICC) measures using partial least squares method. This combined measure strongly predicts future stock market returns, both in-sample and out-of-sample. The predictive power outperforms and complements those of individual ICCs, other combined ICC approaches, as well as macroeconomic and sentiment variables. Cross-sectionally, it strongly predicts various equity portfolio returns, particularly large-size portfolios and portfolios with lower accruals and earnings volatility. The predictive power extends to bond portfolios and monotonically increases with maturities. The results suggest that the combined ICC tracks time-varying discount rate through the macroeconomic uncertainty channel.

Suggested Citation

  • Hoang, Khoa & Cannavan, Damien & Huang, Ronghong & Peng, Xiaowen, 2021. "Predicting stock returns with implied cost of capital: A partial least squares approach," Journal of Financial Markets, Elsevier, vol. 53(C).
    • Handle: RePEc:eee:finmar:v:53:y:2021:i:c:s1386418120300458
    DOI: 10.1016/j.finmar.2020.100576
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    More about this item

    Keywords

    Partial least squares; Implied cost of capital; Risk premium; Market predictability;
    All these keywords.

    JEL classification:

    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • M40 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Accounting - - - General
    • M41 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Accounting - - - Accounting

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