Abstract
Forecasting stock market returns has great significance to asset allocation, risk management, and asset pricing, but stock return prediction is notoriously difficult. In this paper, we combine the sum-of-the-parts (SOP) method and three kinds of economic constraint methods: non-negative economic constraint strategy, momentum of return prediction strategy, and three-sigma strategy to improve prediction performance of stock returns, in which the price-earnings ratio growth rate (gm) is predicted by economic constraint methods. Empirical results suggest that the stock return forecasts by proposed models are both statistically and economically significant. The predictions of proposed models are robust to various robustness tests.
Highlights
The prediction of stock returns has always been a concern of scholars and investors, as it affects some fundamentals of capital budgeting and investment processes [1]
SOP refers to the original SOP model with multiple growths and shrinkages, while CT-SOP, MOP-SOP, and three-sigma SOP denote the SOP models with Campbell and Thompson [8] economic constraint, momentum of predictability (MOP) strategy, and our new three-sigma constraint approach, respectively
Twelve of 14 predictors in the MOP-SOP model had positive certainty equivalent return (CER) gains, and even 8 predictors had more than 1%, they failed to perform better than the SOP method
Summary
The prediction of stock returns has always been a concern of scholars and investors, as it affects some fundamentals of capital budgeting and investment processes [1]. From the out-of-sample stock return forecasts, we can find that the SOP model with CT, three-sigma, and MOP constraints increase the average R2OS by 0.132%, 0.158%, and 0.401%, respectively, compared with SOP model, which indicates that imposing certain restrictions on the SOP model will improve the predictability of stock returns. The average CER gain increased from 0.688% of SOP model to 0.799%, 0.891%, and 0.843% when imposing CT, MOP, and three-sigma constraints, respectively This again supports the evidence that generally combining SOP with three constraints moderately improves out-of-sample economic values.
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