Louis On the Out - of - Sample Predictability of Stock Market Returns

There is an ongoing debate about stock return predictability in time-series data. Campbell (1987) and Fama and French (1989), among many others, find that macro variables such as the dividend yield, the default premium, the term premium, and the shortterm interest rate forecast excess stock market returns. However, Bossaerts and Hillion (1999), Ang and Bekaert (2001), and Goyal and Welch (2003) cast doubt on the in-sample evidence documented by the early authors by showing that these variables have negligible out-of-sample predictive power. In this paper, I provide new evidence of the out-ofsample predictability of stock returns. In particular, I find that the consumption-wealth ratio (cay) by Lettau and Ludvigson (2001)—the error term from the cointegration relation among consumption, wealth, and labor income—exhibits substantial out-of-sample forecasting abilities for stock returns if augmented by a measure of aggregate stock market volatility ( ). 2 jm More important, the improvement of the forecast model of cay augmented by over the model of cay 2 jm by itself is statistically significant. My results reflect a classic omitted-variable problem: While cay and