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Financial Stress and Forecasting UK Equity Risk Premiums

Lookup NU author(s): Dr William Berry, Dr Diemo DietrichORCiD, Professor Robert Sollis

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Abstract

We study the predictability of equity risk premiums for UK equity indexes, in particular whether stylized facts found for the US stock market also apply to the UK market. We compare the performance of economic and technical indicators with a particular focus on the time-varying nature of predictability. Some economic variables are viable and consistent predictors, both in and out of sample. Technical indicators cannot, in general, predict equity premiums. Interestingly, while there is a high degree of time-variability in predictability, the UK business cycle does not account well for it. We thus construct a UK Financial Stress Index to test whether predictability depends on financial stress. In-sample, predictability is indeed highest during financially stressful periods for almost all of the indicators. Out-of-sample, predictability is also highly concentrated around financial stress periods, especially for technical indicators. Our findings suggest that, while the predictability of equity risk premiums appears to be time varying, it is stress in the financial system rather than the business cycle that matters.


Publication metadata

Author(s): Berry W, Dietrich D, Sollis R

Publication type: Working Paper

Publication status: Published

Year: 2021

Publisher: SSRN

URL: https://dx.doi.org/10.2139/ssrn.4053405

DOI: 10.2139/ssrn.4053405


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