Bank of Finland Research Discussion Papers No. 6/2020
Bank of Finland, Helsinki
Any time series can be decomposed into cyclical components fluctuating at different frequencies. Accordingly, in this paper we propose a method to forecast the stock market's equity premium which exploits the frequency relationship between the equity premium and several predictor variables. We evaluate a large set of models and find that, by selecting the relevant frequencies for equity premium forecasting, this method significantly improves in both statistical and economic sense upon standard time series forecasting methods. This improvement is robust regardless of the predictor used, the out-of-sample period considered, and the frequency of the data used.