TAILIEUCHUNG - Earnings Forecasts and the Predictability of Stock Returns: Evidence from Trading the S&P

This magnification of credit risk for preferred stocks occurs essentially because of their payoff structure. If the firm is liquidated at a low value, all other debt holders are paid first and only then are the preferred holders paid. This credit risk is not rewarded with participation in the firm’s upside as it is for common equity holders. Hence, when firm value becomes low, preferred stocks are more acutely exposed to credit risk than common stocks holders. In such a situation of a very low firm value, preferred stock prices can experience declines that are greater than that of. | Earnings Forecasts and the Predictability of stock Returns Evidence from Trading the s p Joel Lander Athanasios Orphanides and Martha Douvogiannis Board of Governors of the Federal Reserve System January 1997 Abstract We develop a simple error-correction model based on a well known theory espoused by Benjamin Graham and David Dodd and others which presumes stock returns tend to restore an equilibrium relationship between the forecasted earnings yield on common stocks and the yield on bonds. The estimation uses I B E S analysts forecasts of s p earnings. To evaluate the model we use rolling regressions to obtain out-of-sample forecasts of excess returns. Tests of association show the implicit timing signals to be statistically significant. Further a strategy of investing in cash when the excess return is forecasted to be negative and in the s p otherwise outperforms the s p yielding higher returns with smaller volatility. Using the bootstrap methodology we demonstrate that the findings are statistically significant. Keywords Asset allocation earnings yield analyst earnings forecasts I B E S s p 500 market timing regression models. JEL Classification System Gil G14. An earlier version of this paper was presented at the October 1996 Conference of the International Association of Financial Engineers in New York City. The opinions expressed are those of the authors and do not necessarily reflect the views of the Board of Governors of the Federal Reserve System. Introduction Among academic researchers conventional wisdom regarding the predictability of stock prices has shifted dramatically over the past couple of decades. While early empirical evidence favored the random walk hypothesis for stock returns accumulating empirical evidence now suggests that stock returns are in fact partly predictable. The initial trickle of evidence in favor of predictability obtained by examining the univariate time series properties of stock prices Lo and MacKinley 1988 Poterba and .

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