Equity Premium Prediction: The Role of Economic and Statistical Constraints

Abstract

This paper shows that the equity premium is predictable out of sample when we use a predictive regression that conditions on a large set of economic fundamentals, subject to: (i) economic constraints on the sign of coefficients and return forecasts, and (ii) statistical constraints imposed by shrinkage estimation. Equity premium predictability delivers a certainty equivalent return of about 2.7% per year over the benchmark for a mean-variance investor. Our predictive framework outperforms a large group of competing models that also condition on economic fundamentals as well as models that condition on technical indicators.

Keywords: Equity Premium, Out-of-Sample Prediction, Economic Fundamentals, Technical Indicators, Shrinkage Estimation.

JEL Classification: G11, G14, G17