Which Variables Predict and Forecast Stock Market Returns?

Abstract

Movements in stock returns arise from changes in expected future discount rates and cash-flow growth. However, which variables best proxy for these changes remains unknown. This chapter considers twenty-five variables arranged into five groups and examines both in-sample predictability and out-of-sample forecasting. Our variables span categories including financial ratios, macro-, labour market and housing variables as well as others, which incorporate measures of sentiment and leverage. Significant in-sample results occur across these five groups. Of note, price ratios, GDP acceleration, inflation, unemployment and consumer sentiment feature prominently. In conducting out-of-sample forecasts, we utilise a range of forecast performance measures and consider single model and combined forecasts. The results show that, with one exception, the combined model forecasts outperform the single model forecasts across all measures. This supports the view that a range of variables from across the economy can help predict future stock returns.