International Stock Return Predictability: What is the Role of the United States?

Abstract

We present significant evidence of out-of-sample equity premium predictability for a host of industrialized countries over the postwar period. There are important differences, however, in the nature of equity premium predictability between the United States and other developed countries. Taken collectively, U.S. economic variables are significant out-of-sample predictors of the U.S. equity premium, while lagged international stock returns have no predictive power. In contrast, lagged international stock returns -- especially lagged U.S. returns -- substantially outperform economic variables as out-of-sample equity premium predictors for non-U.S. countries. The evidence thus points to a leading role for the United States with respect to international return predictability and is consistent with information frictions in international equity markets. The predictability patterns are enhanced during economic downturns, linking return predictability to business-cycle fluctuations and the diffusion of news on macroeconomic fundamentals across countries. The leading role of the United States stands out during the recent global financial crisis: lagged U.S. returns deliver especially sizable gains for forecasting the monthly equity premium in other countries, evidenced by out-of-sample R-squared statistics of 10% or greater, more than triple the postwar average.

Keywords: Out-of-sample equity premium predictability, Predictive regression model, Combination forecast, Information diffusion, Granger causality, Business cycle, Global financial crisis

JEL Classification: C22, C53, E32, G14, G15, G17