Stock Return Prediction and Tactical Investing

• Alpha: Average Return Excess

• TE: Standard Deviation of the Return Excess

The adjust the active beta

• Boom -> Beta > 0

• Downturn -> Beta < 0

It is the excess return adjusted by the systematic risk. It includes fraction of return which does not correlate with the benchmark return and idicates the selction and allocation strategies.

• Absolute

  • Based on total return and total risk

• Relative

  • Same as absolute but with a strict benchmark perspective

  • Benchmark reflects market expectations and is defined independend from the managers expectation

TTA is a short-midterm decision the deviate from the strategy portfolio to outpeform the benchmark

The aggregate return of the active management cannot be positive. After correcting the transaction costs, the average return should be below the benchmark.

The higher the TE, the higher the idiosyncratic risk.

The Benchmark Beta is always 1.

It coincides with the sharpe ratio

The Investment Options of a Manager a restricted by the residual frontier. This is the slope of the IR.

His forecasting skills are increasing

• IC -> Info Coefficient represents the manager skills

• BR -> Breadth is the numbe rof independent investments decisions per year

The Selection dominates, because a low forecasting skill can be compesate with with a large number of forecasts. Therefore, a good forecasting skill cannot compesate a relative low number of forecasts.

If our outcome is negative, our prediction has a higher MSFE than the historical average. Therfore our predicitons are not good

The premiums will disappear

• Selection

  • Under or overweighting of a single assets

• Allocation

  • Under or overweighting of asset classes

• Market-timing

• a -> Excess Return

• TE -> Standard Deviation

• Y -> Riskaversion of the residual risk

The VA is limited by the IR. If The IR Increases -> Forecasting Skills of a Manager increases. Therefore we could generate a higher trade off for our VA function

• transactions costs

• IC is constant, marginal researches are decreasing.

Market-Timing + Jensen alpha

Yes, but only a small predictability. Even in a efficient Market. Equity Risk Premium are predictable due to the ecomoic state. If Prices drop -> we Excpect that Returns in the futue will be high

But a large predictability in the stock market could be signal for market ineffecieny

In this case, the Manger should hold the benchmark portfolio

The Law of active management ist only an approximation of the IR.

• X is the variable to predict equity risk premium

• Rt is the return in excess of the risk free rate

If Investors buy high and sell low due to their risk aversion, they paid a premium. Therefore the buyer will get the premium because he expect high returns.

If High Returns are results from high risk, Investor will recognize these chances but are afraid of it. Investor will not change their portfolio and the high returns will remain

• If Highe Returns do not have higher risks and are decisions are easy, many investors will change their portfolio and invest in the opportunity

• News react Quickly and Investors react quickly and the investment opportunity will vanish

It increases with managers capabilty and decreases with investors risk aversion

< 1% Monthly

The historical MSFE is less or equal than the predictive MSFE.

In the random walk, returns are not predictable. Therefore our beta and RSquared should be zero

• Campbell and Thompson (2008)

  • We can improve if we restrict the coefficients, for example the Equity Premium cannot be negative

• Rhapach and Zhou

  • Diffusion indices

• Macro and technical predictors can improve our predictability

Interes Rate are the most reliable predictors for stock market

Lagged US Returns delivers gains for non US-Countries. Reasons for that are

• US is a large trading partner

• US Stock ist the largest and most liquid stock market

• Selectivity

• Timing

• Strategy