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Title:Equity premium predictions with adaptive macro indexes PDF Logo
Authors:Bai, Jennie
Issue Date:2010
Series/Report no.:Staff Report, Federal Reserve Bank of New York 475
Abstract:Fundamental economic conditions are crucial determinants of equity premia. However, commonly used predictors do not adequately capture the changing nature of economic conditions and hence have limited power in forecasting equity returns. To address the inadequacy, this paper constructs macro indexes from large data sets and adaptively chooses optimal indexes to predict stock returns. I find that adaptive macro indexes explain a substantial fraction of the short-term variation in future stock returns and have more forecasting power than both the historical average of stock returns and commonly used predictors. The forecasting power exhibits a strong cyclical pattern, implying the ability of adaptive macro indexes to capture time-varying economic conditions. This finding highlights the importance of using dynamically measured economic conditions to investigate empirical linkages between the equity premium and macroeconomic fundamentals.
Subjects:Adaptive macro index
forecasting
JEL:G17
C58
Document Type:Working Paper
Appears in Collections:Staff Reports, Federal Reserve Bank of New York

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