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Should we expect significant out-of-sample results when predicting stock returns?
Using Monte Carlo simulations, I show that typical out-of-sample forecast exercises for stock returns are unlikely to produce any evidence of predictability, even when there is in fact predictability and the correct model is estimated.
Expected stock returns and variance risk premia
We find that the difference between implied and realized variances, or the variance risk premium, is able to explain more than fifteen percent of the ex-post time series variation in quarterly excess returns on the market portfolio over the 1990 to 2005 sample period, with high (low) premia predicting high (low) future returns. The magnitude of the return predictability of the variance risk premium easily dominates that afforded by standard predictor variables like the P/E ratio, the dividend yield, the default spread, and the consumption-wealth ratio (CAY). Moreover, combining the variance ...