A0521
Title: Equilibrium error and expected industry portfolio returns
Authors: Victor Troster - Universitat de les Illes Balears (Spain) [presenting]
Jose Penalva - Universidad Carlos III de Madrid (Spain)
Abderrahim Taamouti - Durham University Business School (United Kingdom)
Abstract: The equilibrium error, the error term from the cointegration relationship between industry portfolio cumulative returns and excess stock market cumulative returns, is found to have strong predictive power for future industry portfolio returns. Since only the unexpected component of a state variable should command a risk premium, we take deviations from the common long-term relationship between industry portfolio cumulative returns and excess stock market cumulative returns, which proxy for changes in the investment opportunity set. In line with gradual information diffusion across connected industries, these changes in the investment set will lead to stock return predictability by informed investors. We also show that the out-of-sample explanatory power is economically meaningful for investors. Simple trading strategies implied by the proposed predictability provide portfolios with higher mean returns and Sharpe ratios than a buy-and-hold or a benchmark strategy does.
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