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Understanding stock return predictability

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  • Hui Guo
  • Robert Savickas

Abstract

Over the period 1927:Q1 to 2005:Q4, the average CAPM-based idiosyncratic variance (IV) and stock market variance jointly forecast stock market returns. This result holds up quite well in a number of robustness checks, and we show that the predictive power of the average IV might come from its close relation with systematic risk omitted from CAPM. First, high lagged returns on high IV stocks predict low future returns on the market as a whole. Second, returns on a hedging portfolio that is long in stocks with low IV and short in stocks with high IV perform as well as the value premium in explaining the cross-section of stock returns. Third, realized variance of the hedging portfolio or of the value premium is closely correlated with the average IV, and these variables have similar predictive power for stock returns.

Suggested Citation

  • Hui Guo & Robert Savickas, 2006. "Understanding stock return predictability," Working Papers 2006-019, Federal Reserve Bank of St. Louis.
    • Handle: RePEc:fip:fedlwp:2006-019
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    Cited by:

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    2. Yufeng Han, 2010. "On the Economic Value of Return Predictability," Annals of Economics and Finance, Society for AEF, vol. 11(1), pages 1-33, May.
    3. Majumder, Debasish, 2013. "Towards an efficient stock market: Empirical evidence from the Indian market," Journal of Policy Modeling, Elsevier, vol. 35(4), pages 572-587.

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