Sector return predictability with a link to the business cycle

Jonas B√łegh-Lervang

Student thesis: Master thesis


Time-series predictability of asset prices has been one of the most debated subjects in the field of financial economics, both in an academic and practical context. It is generally accepted among financial economists that return predictability is present and a rational implication of dynamic asset pricing models. Although the empirical literature in financial economics has produced increased evidence of time-series return predictability, the evidence has mainly been relating to the aggregated return of an asset class. This is primarily relevant for multi-asset managers such as pension and endowment funds managers who can allocate between different asset classes. But equity only managers optimize within a single asset class space and hence cannot allocate funds to other asset classes. In this thesis the issue of equity sector return predictability and its link to the business cycle is addressed. The motivation of the thesis is to expand the return predictability debate to include sector return due to the potential importance for an equity only investor. The thesis explores the link between equity sector return and the business cycle. Furthermore, it explores whether it is possible to predict the nominal and excess return of a given sector based on lagged timeseries of a set of 15 theoretically and empirically motivated information variables. In addition, it is analyzed if the return predictability component is conditional on the business cycle. The thesis tests for in-sample and out-of-sample performance of the predictive regression models. To improve the out-of-sample results a forecast combination approach is applied. The overall conclusion from the thesis is that equity sector return contains a predictability component which is time-varying and linked to the business cycle. The predictability component is more evident in nominal return than in excess return and is more evident for cyclical sectors than for non-cyclical sectors. The investors can achieve utility gain from applying predictive regression models of equity sector return in the asset allocation decision. However, these gains shall be seen as a compensation for risk premiums and not as an opportunity for generating abnormal profit. Furthermore, there is a considerable number of econometric issues relating to return predictability and both the in-sample and out-of-sample goodness-of-fit are found to be relatively small.

EducationsMSc in Applied Economics and Finance, (Graduate Programme) Final Thesis
Publication date2010
Number of pages116