DP12885 Pockets of Predictability

Author(s): Leland Farmer, Lawrence Schmidt, Allan G Timmermann
Publication Date: April 2018
Keyword(s): affine asset pricing models, cash flows, incomplete learning, Markov switching predictive systems, Predictability of stock returns
JEL(s):
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=12885

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.