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Stock Return Predictability and Seasonality Analysis

Last Updated on 10 February, 2024 by Rejaul Karim

Stock Return Predictability and Seasonality,” authored by Keunsoo Kim and Jinho Byun, examines Shiller’s Cyclically Adjusted Price-Earnings (CAPE) ratio.

The research shows that the CAPE ratio can forecast 12-month CRSP returns. It also demonstrates the Halloween effect’s strong presence in US stock markets, even during periods reported as weak or negative.

This intriguing pattern influences suggested investment strategies, offering investors unique insights into navigating the market’s complexities. Overall, the study uncovers riveting aspects of stock return predictability and seasonality, reinforcing the importance of understanding market cycles.

Abstract Of Paper

An examination of the Shiller cyclically adjusted pricing-earnings (CAPE) ratio reveals its forecasting power for 12-month CRSP equally weighted (EW) excess returns and value weighted (VW) excess returns. The 12-month EW excess returns following low CAPE ratios are, on average, 20.7% higher than those following high CAPE ratios for the period of 1927-2016. This dichotomy in the Shiller CAPE ratio has a more reliable predictability than the January barometer. Previous studies report that the Halloween indicator was weak or negative in the US stock market prior to the 1950s. We find that the Halloween effect is strongly present following high CAPE ratios, even for the period of 1926-1971. Our results recommend a practical investment strategy. More specifically, if the CAPE ratio in September is lower than the 36-month median of the CAPE ratio, invest in stock markets from November to October of the following year; otherwise, invest for six months from November to April and sell in May and go away.

Original paper – Download PDF

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Author

Keunsoo Kim
Graduate School of Pan-Pacific International Studies

Jinho Byun
Ewha Womans University – College of Business Administration

Conclusion

The research paper “Stock Return Predictability and Seasonality,” elucidates the forecasting ability of Shiller’s cyclically adjusted pricing-earnings (CAPE) ratio for 12-month CRSP returns. It provides compelling evidence of higher excess returns following low CAPE ratios compared to high ones. It surpasses the January barometer in reliability of predictability, inspiring more confidence.

Additionally, the study challenges conventional views about the Halloween effect’s impact on the US stock market. The effect exhibits a stronger presence following high CAPE ratios, defying expectations based on prior research.

Furthermore, a practical investment strategy hinging on the CAPE ratio is proposed, offering investors a valuable tool to enhance their market decisions.

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FAQ

What is the main contribution of the research paper “Stock Return Predictability and Seasonality” to our understanding of stock market dynamics?

The paper contributes by demonstrating the forecasting power of Shiller’s cyclically adjusted pricing-earnings (CAPE) ratio for 12-month CRSP returns. It shows a significant dichotomy in returns based on CAPE ratios, providing insights that surpass the reliability of the January barometer. This enhances our understanding of how valuation metrics, specifically CAPE ratios, can offer predictive power for future stock returns.

How does the research challenge conventional views regarding the Halloween effect in the US stock market?

The study challenges prior beliefs about the Halloween effect, showing that it is strongly present following high CAPE ratios, even for the period before the 1950s. This finding goes against previous reports suggesting a weak or negative Halloween effect in the early years of the US stock market. The research sheds light on the nuanced relationship between market seasonality and valuation metrics.

What practical investment strategy does the research propose based on the findings?

The research recommends a practical investment strategy tied to the CAPE ratio. Specifically, if the CAPE ratio in September is lower than the 36-month median of the CAPE ratio, the strategy suggests investing in stock markets from November to October of the following year. Otherwise, the strategy recommends investing for six months from November to April and selling in May and going away. This proposed strategy offers investors a clear and actionable approach based on the insights derived from the CAPE ratio.

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