Abstract

In this paper we present new evidence on the predictability of stock returns, and examine the extent to which time variation in expected returns on the market portfolio and other portfolios is due to time variation in the risk exposure of these portfolios or due simply to mispricing or sentiment.

In doing this we develop two new models for the prediction of stock market returns, one risk-based, and the other purely statistical; both models rely on extracting information from past returns of portfolios. The pricing kernel model expresses the expected excess return as the covariance of the market return with a pricing kernel that is a linear function of portfolio returns.

The discount rate model is based on the log-linea present value model od Campbell and Shiller and predicts the expected excess return directly as a function of weighted past portfolio returns. For aggregate market returns the two models provide independent evidence of predictable variation in returns, with R2 of 5-8% for quarterly returns and 8-17% for annual return. For spread portfolio returns, such as HMZ and HML , the story is different and we find considerable evidence of predictability from the discount rate model that is not captured by the risk based model , and the expected returns on these spread portfolios are found to be strongly related to measures of sentiment.