Predicting Stock Returns

This paper studies whether incorporating business cycle predictors is beneficial to a real time optimizing investor who must allocate funds across 3123 NYSE-AMEX stocks and the risk-free asset over the 1972-2003 period. Realized returns are positive when adjusted by the Fama-French and momentum factors as well as by the size, book-to-market, and momentum characteristics. The investor optimally holds small-cap, growth, and momentum stocks and loads less (more) heavily on momentum (small-cap) stocks over recessions. Conditioning on business cycle predictors is beneficial to a real time optimizing investor because such variables drive stock-level alpha and beta variations. Indeed, returns on individual stocks are predictable out-of-sample even when the equity premium predictability, the major focus of previous work, is questionable.

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