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Cape vs the fed model: comparative analysis of the out-of-sample performance in predicting future stock returns

Poluianova, Marina; Meshcheriakov, Georgii
Master thesis
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URI
http://hdl.handle.net/11250/2477121
Date
2017
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  • Master of Science [1116]
Abstract
The goal of this thesis is to compare the out-of-sample performance in

predicting future stock returns of the Fed model and Shiller's cyclically

adjusted price-to-earnings ratio (CAPE). The two models are also augmented

with 10-year Treasury bond yield. Additionally, a version of CAPE that uses

after-tax corporate pro ts and a Fed model adjusted for perceived risk are

analyzed. The four models are tested using US market time series in a period

ranging from 1871 to 2016 using regression analysis and compared using

visual inspection of plots, forecast statistics, and forecast equivalence tests.

We nd that in-sample and out-of-sample tests show low R2, which may still

have economic signi cance for risk-averse investors. Versions of CAPE model

dominate the Fed model alternatives in-sample. Out-of-sample, traditional

CAPE exhibits very limited ability to generate accurate forecasts for long

investment horizons of 20 years, while Fed model performs better at 1-year

horizon. Alternative versions of the two models do not exhibit signi cant

improvement in equity return predictability. So, for strategic asset allocation,

CAPE and Fed should be used with caution as complementary tools and in

conjunction with diversi cation.
Description
Masteroppgave(MSc) in Master of Science in Business, Finance - Handelshøyskolen BI, 2017
Publisher
BI Norwegian Business School

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