2018-14 | August 2020
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Examining the Sources of Excess Return Predictability: Stochastic Volatility or Market Inefficiency?
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) predictable investor forecast errors that give rise to market inefficiency. While controlling for stochastic volatility, we find that a variable which interacts the 12-month consumer 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---periods that coincide with heightened investor attention to the stock market as measured by a Google search volume index. The resulting pessimism appears to motivate many investors to sell stocks, putting further downward pressure on stock prices, which contributes to a lower excess stock return over the next month.
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Lansing, Kevin J, Stephen F. LeRoy, and Jun Ma. 2018. "Examining the Sources of Excess Return Predictability: Stochastic Volatility or Market Inefficiency?," Federal Reserve Bank of San Francisco Working Paper 2018-14. Available at https://doi.org/10.24148/wp2018-14