Working Paper

Examining the Sources of Excess Return Predictability: Stochastic Volatility or Market Inefficiency?


Abstract: We use a consumption based asset pricing model to show that the predictability of excess returns on risky assets can arise from only two sources: (1) stochastic volatility of model variables, or (2) departures from rational expectations that give rise to predictable investor forecast errors and market inefficiency. From an empirical perspective, we investigate whether 1-month ahead excess returns on stocks can be predicted using measures of consumer sentiment and excess return momentum, while controlling directly and indirectly for the presence of stochastic volatility. A variable that interacts the 12-month sentiment change with recent return momentum is a robust predictor of excess stock returns both in-sample and out-of-sample. The predictive power of this variable derives mainly from periods when sentiment has been declining and return momentum is negative, forecasting a further decline in the excess stock return. We show that the sentiment-momentum variable is positively correlated with fluctuations in Google searches for the term ?stock market,? suggesting that the sentiment-momentum variable helps to predict excess returns because it captures shifts in investor attention, particularly during stock market declines.

JEL Classification: E44; G12;

https://doi.org/10.24148/wp2018-14

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Bibliographic Information

Provider: Federal Reserve Bank of San Francisco

Part of Series: Working Paper Series

Publication Date: 2018-12-03

Number: 2018-14

Pages: 49 pages