Time-Varying Short-Horizon Return Predictability: Sam James Henkel, J. Spencer Martin, Federico Nardari

Motivation
Dynamics
Methodology
Data
Results & Robustness
Conclusion
Time-Varying Short-Horizon Return Predictability

Sam James Henkel, J. Spencer Martin, Federico Nardari
Kelley, Tepper, Bauer Schools Indiana, Carnegie Mellon, Houston October 13, 2008
Henkel, Martin and Nardari Time-Varying Return Predictability
Indiana, Carnegie-Mellon, Houston
Motivation
Dynamics
Methodology
Data
Conclusion
Predictability: Old School

From 1890 to 1965, return predictability was a perennial hot topic. Predictors: Charles Dow, Irving Fisher, Benjamin Graham
Skeptics: Louis Bachelier, Alfred Cowles, nascent Econometrics Society
Eciency: Paul Samuelson, Benoit Mandelbrot, Eugene Fama The Random Walk hegemony then cemented into place and dominated thinking.
Henkel, Martin and Nardari Time-Varying Return Predictability Indiana, Carnegie-Mellon, Houston
Motivation
Dynamics
Methodology
Data
Conclusion
Predictability: New School
From 1980 or so, return predictability made a revival.
Rening Notions of Eciency: Grossman, Stiglitz, Stokey, Milgrom, et al. Viability of Predictors: a raft of papers showed market returns predicted by various indicators, such as dividend yields Usefulness and Implications: touching o debates over asset allocation, over consumption-based theories of asset pricing, etc.
Motivation
Dynamics
Methodology
Data
Conclusion
Motivation: Problem Statement
In the 1990s, return predictability vanished. Why?
It was never there a Mirage [BH 99, GW 03, 04] Only there at short horizons [AB 07, BRW 07] Parameter Instability: A Structural Break? [V 97, LVN 06] Parameter Instability: Random Breaks [NW 00, PT 02] Non-Random Breaks [this paper]
Motivation
Dynamics
Methodology
Data
Conclusion
Our Approach
1. Method: We match dynamics of predictors to the dynamics of returns. Most of the focus has been on the dynamics of the equity premium alone 2. Result: Predictability appears to be a property of recessions but NOT expansions: Adj R 2 15% vs. 0%. 3. Robustness: We eliminate alternative explanations.
Motivation
Dynamics
Methodology
Data
Conclusion
Predictability Research in Context (Fig. 1)

60%
Default Premium Predicts

Chen, Roll & Ross 1986 Keim & Stambaugh 1986
Cumulative Proportion of Recession Data in CRSP Sample
Term Premium Predicts

50% Fama 1984 Keim & Stambaugh 1986 Campbell 1987, Harvey 1987
Short Rate Predicts

40% Fama & Schwert 1977 Fama 1981 Geske & Roll 1983
Predictability Illusory?
Goyal & Welch 2003 Valkanov 2003 Ang & Bekaert 2007 Cochrane 2006
Random Walk
30% Fama 1965 Fama 1970
Predictability Debatable Dividend Yield Predicts

Ball 1978 Rozeff 1984 Shiller 1984 Richardson & Stock 1989 Hodrick 1992 Goetzmann & Jorion 1993 Kim & Nelson 1993
% RSVAR Recession Months M h
20%
10%
% NBER Recession Months
0% 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Date
Motivation
Dynamics
Methodology
Data
Conclusion
Predictability and Recessions

The adjusted R-sq is from regressing next periods market return on previous current months predictors (Dividend yield, short rate, term spread and default spread) from the starting month (1953.04 or 1962.07) to the current month.
Full Sample 1 0.9 Percent Recession Data and AdjRsq 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 1950 Adjusted Rsq Percent NBER Recession Data Percent Recession Data and AdjRsq 0.5 0.4 0.3 0.2 0.1 0 0.1 0.2 0.3 0.4 0.5 1960 Adjusted Rsq Percent NBER Recession Data CRSP Sample
1960
1970
1980 Date
1990
2000
2010
1970
1980 Date
1990
2000
2010
The
correlation is 70 to 90% depending on time periods used.
Motivation
Dynamics
Methodology
Data
Conclusion
Plan of Inquiry
1. Dynamics 2. Methodology 3. Data 4. Main Results 5. Supporting Results 6. Conclusion
Motivation
Dynamics
Methodology
Data
Conclusion
A Model of Expected Returns

A prevailing model of expected returns
e Rvw , t+1 = 0 + 1 DYt + 2 SRt + 3 TERMt + 4 DEFt + t+1
Based on Ferson & Harvey [1991] and recently used in Chordia & Shivakumar [2002], Avramov & Chordia [2006], and Petkova & Zhang [2006]. Choice of Variables These are precisely-measured, high-frequency, market-traded, ex ante quantities Other macro factors can be relatively poorly measured, low-frequency, lagged and often-revised government statistics
Motivation
Dynamics
Methodology
Data
Conclusion
Dynamics of Predictors: The Short Rate

Chan Karolyi Longsta Sanders (1992) nest 8 theoretical models: dr = ( + r )dt + r dW .
Model Name Merton Vasicek CIR SR Dothan GBM Brennan-Schwatrz CIR VR CEV Form dr dr dr dr dr dr dr dr = = = = = = = = dt + dZ ( + r )dt + dZ ( + r )dt + r 1/2 dZ rdZ rdt + rdZ ( + r )dt + rdZ r 3/2 dZ rdt + r dZ Restrictions 0 0 0 1/2 1 1 1 3/2
(1)
0 0 0 0
Their GMM tests reject all models with < 1, but unfortunately, models with 1 are nonstationary.
Henkel, Martin and Nardari Time-Varying Return Predictability Indiana, Carnegie-Mellon, Houston
Motivation
Dynamics
Methodology
Data
Conclusion
Dynamics of Predictors
Regime-switching Short Rate: Ball and Torous [1995] and Gray [1996] Regime 1 Low mean, low volatility and follows a random walk Regime 2 High mean, high volatility and mean-reverting Miron and Mankiw [1986] - in normal times, the fed smooths interest rates and they are uninformative. Davig and Leeper [2007] generalize the Taylor Rule as a regime-switching process. Regime-switching Term Structure Dynamics: Ang & Bekaert [2002], Bansal & Zhou [2002], Bansal, Tauchen and Zhou [2004]
Motivation
Dynamics
Methodology
Data
Conclusion
Dynamics of Predictors
Dividend dynamics are complicated. Dividends are smoothed - Lintner [1956], Marsh & Merton [1986], Brav, Graham, Harvey, Michaely [2005]. Smoothing is harder to do in bad times. Possibility of switching-type behavior, but hard to detect. Some evidence in Timmmermann [1994] and Bansal, Dittmar & Lundblad [2005].
Motivation
Dynamics
Methodology
Data
Conclusion
Predictor Dynamics: Dierences in Persistence

Adapted from Table 1 Panel E. Half Life is the time in months to dissipate half of a unit shock to a given predictor variable. Longer half lives mean more persistent predictors. Dierences in Half-lives Across Regimes (Expansions - Recessions) Country Canada France Germany Italy Japan United Kingdom United States DY 54.8 17.0 24.4 38.8 24.6 33.4 6.1 SR 29.7 35.2 53.4 51.9 29.1 44.7 44.2 TERM 41.8 21.2 34.3 17.0 29.6 43.4 14.8 DEF 7.3
8.6
Bold: The 95% Highest Posterior Density interval does not include zero.
Predictors are far more persistent in good times.
Motivation
Dynamics
Methodology
Data
Conclusion
Predictor Dynamics: Dierences in Volatility

Adapted from Table 1 Panel D. Dierences in Volatilities Across Regimes (Recession - Expansion) Country Canada France Germany Italy Japan United Kingdom United States
e Rvw 100
DY 100 -3.7 2.1 3.9 4.2 10.7 -5.6 3.2
SR10 9.8 -1.3 5.5 -3.4 -2.0 -0.8 1.4
TERM10 2.0 1.4 1.0 1.5 2.7 3.1 2.4
DEF 10 2.1
3.1 2.0 1.0 2.4 1.5 4.1 2.4
2.4
While market volatility is higher in recessions, so too are the volatilities of predictors.
Motivation
Dynamics
Methodology
Data
Conclusion
Framework
Good times
As if interest rates are smoothed by the Fed Firms manage earnings and smooth dividends
Bad times
As if interest rates are NOT smoothed by the Fed (Some) rms face binding nancial constraints
Therefore, these signals should be informative in bad times.
Motivation
Dynamics
Methodology
Data
Conclusion
Methodology
Choice of Horizon 1 month ahead predictability
Matches up well with ICAPM and cross-sectional research No overlapping regressions Longer horizons would blur the results as the transition probability matrix converges to its stationary distribution Rolling regressions as in Goyal and Welch may also wash out the eects
Identify Good and Bad times:

NBER/SPF/Livingston dates & Conditional Regressions Regime-Switching Vector Autoregressions (RSVARs)
Motivation
Dynamics
Methodology
Data
Conclusion
RSVAR Specication
The RSVAR takes the following form, zt = A(st )zt1 + (st ), where
e zt =(Rvw , t , DYt , SRt , TERMt , DEFt ) ,
(2)
st [0, 1] indicates the (latent) system state A(st ) is the state-dependent companion matrix (st ) is the state-dependent error covariance matrix
Important work on similar specications by Hamilton, Krolzig, Kim & Nelson, Timmermann and coauthors, Ang & Bekaert, Bansal, Tauchen & Zhou.
Motivation
Dynamics
Methodology
Data
Conclusion
Estimation: Bayesian MCMC

With two states, ve variables, and a diagonal error matrix, there would be 72 total parameters to estimate, and a potential host of issues to deal with. The Bayesian (MCMC, Markov Chain Monte Carlo) approach that we have chosen tackles: Latent states estimation Persistent lagged endogenous regressors Model selection (especially, number of regimes) Non-standard asymptotics needed given nuisance parameters under the null Small sample issues (i.e., recessions are short) Distribution of test statistics (no established asymptotics for functions of interest: dierence in R-sq, components of R-squared,...) Distribution of out-of-sample forecasts High-dimensionality in multi-country specications
Motivation
Dynamics
Methodology
Data
Conclusion
Methodology: Regime/State Identication

The diagnostic called RCM is a measure of goodness of t with respect to regimes, 0 RCM(x) 1. if RCM(x) is near 1, then x regimes is a good description of the data.
RCM(M) RCM(2)
= =
1 M M T 1
t=1 m=1
P(st = m|t1 )
1 4 Avg [Pt|t1 (1 Pt|t1 )] = 88%
88% is for the US. RCM(2) ranges from 82% to 91% for the countries in our sample. Two states/regimes do a good job of describing the data.
Motivation
Dynamics
Methodology
Data
Conclusion
Business Cycles? RSVAR States vs NBER Regimes

77% agreement between US RSVAR regimes and NBER dates:
1.5
Ex Ante Prob [s(t)=Recession|s(t-1)]
0.5
-0.5 195303 195409 195603 195709 195903 196009 196203 196309 196503 196609 196803 196909 197103 197209 197403 197509 197703 197809 198003 198109 198303 198409 198603 198709 198903 199009 199203 199309 199503 199609 199803 199909 200103 200209 200403 200509
Date
Motivation
Dynamics
Methodology
Data
Conclusion
Data: Sources
US Data from CRSP and FRED Market Returns and Dividend Yields from CRSP Dividend yields adjusted for Share Repurchases as in BDL [2006] Short Rate, TERM and Default Spreads from FRED Spans 1953.03-2007.12, 658 periods G7 data from Global Financial, Global Insight, and Datastream Market Returns and Dividend Yields from Datastream Short Rate and Long Govt Bond Yields from Global Financial and Global Insight Start dates ranging from 1965 to 1973 At least 412 periods per country
Motivation
Dynamics
Methodology
Data
Conclusion
Sample Range
From Table 1 Panel A: Sample Characteristics Country Canada France Germany Italy Japan United Kingdom United States Start 1973.02 1973.01 1973.01 1973.01 1973.06 1965.01 1953.03 End 2007.12 2007.12 2007.12 2007.12 2007.09 2007.12 2007.12 Periods 419 420 420 420 412 516 658 Recession 69 91 60 71 99 93 184
About 35 to 55 years of data per country, or a few business cycles.
Motivation
Dynamics
Methodology
Data
Conclusion
Predictability in Good and Bad Times

From Table 2: Explanatory Power (Average Adjusted R 2 s, 50,000 draws) Country Canada France Germany Italy Japan United Kingdom United States Full Sample 3.0 3.0 1.5 0.9 -1.9 5.0 4.9 Expansion 1.1 3.5 2.2 0.6 2.1 1.5 0.4 Recession 15.4 7.3 9.0 12.9 18.2 25.3 17.5 Dierence 14.3 3.8 6.8 12.3 16.1 23.8 17.1
Bold: The 95% Highest Posterior Density interval does not include zero. Italic: The 90% Highest Posterior Density interval does not include zero.
Motivation
Dynamics
Methodology
Data
Conclusion
Specication Tests: Are There Regimes in Coecients?

The Bayesian analog to a nested/restricted model test is a calculation of posterior odds ratios. The marginal likelihood of the data given regime switching coecients is compared to the marginal likelihood given constant coecients (i.e., only one regime). The higher the odds ratio, the stronger the rejection of constant coecients. From Table 3 Panel A:
Posterior Odds Ratios Against Jointly Constant Coecients Country Canada France Germany Italy Japan United Kingdom United States Odds Ratio 20.15 15.66 0.006 5.13 183.37 11.12 199.04 Evidence Against Constant Coecients Strong Strong Minimal/Not Worth Mentioning Substantial Decisive Strong Decisive
Motivation
Dynamics
Methodology
Data
Conclusion
Coecient Dierences
Looking across the collection of coecient estimates, recession estimates tend to have greater magnitude than expansion estimates. From Table 3 Panel B:
Canada DYt1 SRt1 TERMt1 DEFt1
Expansion 0.982 [ 0.059 , 2.417 ] -0.128 [ -0.352 , 0.085 ] 0.029 [ -0.320 , 0.391 ] -0.431 [ -1.901 , 1.007 ]
Recession 5.286 [ 0.389 , 12.147 ] -1.113 [ -1.853 , -0.394 ] -0.922 [ -2.265 , 0.433 ] 5.021 [ 0.560 , 9.313 ]
Dierence 4.304 [ 0.100 , 11.387 ] -0.985 [ -1.760 , -0.223 ] -0.952 [ -2.367 , 0.458 ] 5.451 [ 0.708 , 10.068 ]
95% HPD intervals in [ ] brackets.
Motivation
Dynamics
Methodology
Data
Conclusion
Where does the recession action come from?
Higher predictability is not necessarily unexpected. It depends on the source . . . For the regression of y on predictors x1 . . . xk ,
k
R2 =
i=1
i2 R2)
i2 2 y
+
i=j
i j ij . 2 y
Does more predictability (higher variances, or from the cross terms?
come from the betas, from the relative
Motivation
Dynamics
Methodology
Data
Conclusion
R 2 Decomposition
Distilled from Table 4: Decompositions of R 2 across Regimes (G7 Averages) Sources of R 2 Expansion Recession R2
e Rvw DY SR TERM DEF Crossterms
Squared Betas Expansion Recession
Relative Variances Expansion Recession
1.6 Sum of: 0.27 0.90 0.86 0.47 0.10 -0.90
15.1
3.23 17.46 21.64 4.53 12.60 -35.37
0.00 1.93 0.02 0.13 0.24
0.05 128.42 1.03 1.27 20.13
116.03 0.63 46.89 7.21 0.65
72.03 0.36 25.13 4.07 0.65
Changes in relative variances do not explain changes in predictability.
Motivation
Dynamics
Methodology
Data
Conclusion
Robustness: Negative Expected Returns?

Imposing increasingly strict priors ruling out negative expected returns does not change the character of the results. If anything, estimated market risk premia tend to be higher in recessions. From Table 5 Panel A:
Country Canada France Germany Italy Japan United Kingdom United States
Expansion 0.536 [ 0.058,1.167 0.647 [ 0.116,1.332 0.467 [ 0.040,1.180 0.525 [ 0.049,1.295 0.376 [ 0.018,1.093 0.456 [ 0.116,0.919 0.635 [ 0.039,1.501
] ] ] ] ] ] ]
Recession 0.470 [ 0.022,1.277 0.771 [ 0.066,1.660 0.545 [ 0.031,1.405 0.714 [ 0.061,1.722 0.393 [ 0.018,1.093 0.668 [ 0.055,1.489 0.723 [ 0.064,1.589
] ] ] ] ] ] ]
Dierence -0.066 [ -0.881,0.875 0.124 [ -0.867,1.179 0.078 [ -0.837,1.050 0.189 [ -0.854,1.326 0.017 [ -0.823,0.862 0.212 [ -0.540,1.091 0.087 [ -1.016,1.179
] ] ] ] ] ] ]
95% HPD intervals in [ ] brackets.
Motivation
Dynamics
Methodology
Data
Conclusion
Alternative classications of good and bad times

Does the RSVAR pick up current or expected business conditions? For the US, two independent classications based upon expectations are available: SPF and Livingston data. From Table 6:
Adjusted R 2 Classication NBER (Monthly) SPF (Quarterly) NBER (Quarterly) Livingston (Semiannual) NBER (Semiannual) Expansion 1.5 2.6 3.7 21.2 5.3 Recession 27.8 45.3 37.2 19.2 48.6 Dierence 26.3 42.6 33.5 -2.0 43.3
Motivation
Dynamics
Methodology
Data
Conclusion
Did Predictability Disappear? (Table 7)

Panel A. NBER Business Cycle Dates Business Cycle NBER Expansions Cycle 1 1975.04 - 1979.12 Cycle 2 1980.08 - 1981.06 Cycle 3 1982.12 - 1990.06 Cycle 4 1991.04 - 2001.02 NBER Recessions 1980.01 - 1980.07 1981.07 - 1982.11 1990.07 - 1991.03 2001.03 - 2001.11
Panel B. The Dividend Yield Business Cycle NBER Cycle 1 Cycle 2 Cycle 3 Cycle 4 Panel C. The Short Rate Business Cycle Cycle 1 Cycle 2 Cycle 3 Cycle 4
Expansions 0.09 0.37 0.12 0.04
NBER Recessions 0.35 0.56 0.59 0.09
NBER Expansions -0.04 -0.36 -0.02 -0.03
NBER Recessions -0.68 -0.70 -0.72 -0.31
Motivation
Dynamics
Methodology
Data
Conclusion
Did Predictability Disappear? (Table 7)

Panel A. NBER Business Cycle Dates Business Cycle NBER Expansions Cycle 1 1975.04 - 1979.12 Cycle 2 1980.08 - 1981.06 Cycle 3 1982.12 - 1990.06 Cycle 4 1991.04 - 2001.02 NBER Recessions 1980.01 - 1980.07 1981.07 - 1982.11 1990.07 - 1991.03 2001.03 - 2001.11
Panel D. The Term Spread Business Cycle NBER Expansions Cycle 1 0.07 Cycle 2 0.26 Cycle 3 -0.07 Cycle 4 -0.00
Panel E. The Default Spread Business Cycle NBER Expansions Cycle 1 0.17 Cycle 2 -0.47 Cycle 3 0.13 Cycle 4 -0.00
Motivation
Dynamics
Methodology
Data
Conclusion
Summary of Findings and Extensions
1 If predictability exists, it does so primarily in recessions. 2 Predictability seems dependent on changing predictor dynamics as well as the equity premium. 3 Results are robust to common econometric problems posed by return predictability
Motivation
Dynamics
Methodology
Data
Conclusion
Summary of Findings and Extensions
4 All results are in-sample the statistical arms race regarding the exploitability is still an open question. 5 Ties to GE model, term structure constraints are possible extensions, as are out-of-sample results. 6 As a practical matter, because predictability is concentrated during times of high market volatility, the importance to mean-variance investors may be overstated.
Motivation
Dynamics
Methodology
Data
Conclusion
Corollary
Common nancial indicators matter more in bad times.

Time-Varying Short-Horizon Return Predictability: Sam James Henkel, J. Spencer Martin, Federico Nardari

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