Equity premium prediction: Taking into account the role of long, even asymmetric, swings in stock market behavior

Abstract

Through a novel approach, this paper shows that substantial change in stock market behavior has a statistically and economically significant impact on equity risk premium predictability both on in-sample and out-of-sample cases. In line with Auer’s “B ratio”, a “Bullish index” is introduced to measure the changes in stock market behavior, which we describe through a “fluctuation detrending moving average analysis” (FDMAA) for returns. We consider 28 indicators. We find that a “positive shock” of the Bullish Index is closely related to strong equity risk premium predictability for forecasts based on macroeconomic variables for up to six months. In contrast, a “negative shock” is associated with strong equity risk premium predictability with adequate forecasts for up to nine months when based on technical indicators.