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Discussion Paper Details

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Title: Pockets of Predictability

Author(s): Leland Farmer, Lawrence Schmidt and Allan Timmermann

Publication Date: April 2018

Keyword(s): affine asset pricing models, cash flows, incomplete learning, Markov switching predictive systems and Predictability of stock returns

Programme Area(s): Financial Economics

Abstract: Return predictability in the U.S. stock market is local in time as short periods with significant predictability (`pockets') are interspersed with long periods with little or no evidence of return predictability. We document this empirically using a flexible non-parametric approach and explore possible explanations of this finding, including time-varying risk premia. We find that short-lived predictability pockets are inconsistent with a broad class of affine asset pricing models. Conversely, pockets of return predictability are more in line with a model with investors' incomplete learning about a highly persistent growth component in the underlying cash flow process which undergoes occasional regime shifts.

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Bibliographic Reference

Farmer, L, Schmidt, L and Timmermann, A. 2018. 'Pockets of Predictability'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=12885