International Review of Financial Analysis 63 (2019) 1–9

Contents lists available at ScienceDirect

International Review of Financial Analysis

journal homepage: www.elsevier.com/locate/irfa

Economic constraints and stock return predictability: A new approach T

a b,⁎ c c
Yaojie Zhang , Yu Wei , Feng Ma , Yongsheng Yi
a
School of Economics and Management, Nanjing University of Science and Technology, Nanjing, China
b
School of Finance, Yunnan University of Finance and Economics, Kunming, China
c
School of Economics and Management, Southwest Jiaotong University, Chengdu, China

ARTICLE INFO ABSTRACT

JEL classifications: In this paper, we propose a new approach to impose economic constraints on the time-series forecasts of stock
C32 return. It is unlikely or risky for a rational investor to rely on forecast outliers to trade stocks. Given this, our new
C53 constraint approach truncates the stock return forecasts at the extremely positive and negative values. The
C58 empirical results suggest that the new economic constraint approach generate more accurate and reliable return
G11
forecasts than the unconstrained method for both univariate regression models and multivariate models.
G17
Furthermore, our new constraint approach also outperforms two prevailing constraint approaches of Campbell
Keywords: and Thompson (2008) and Pettenuzzo, Timmermann, and Valkanov (2014). In addition, a mean-variance in-
Stock return predictability
vestor can realize sizeable economic gains by using our new constraint approach to allocate asset relative to
Economic constraints
using unconstrained counterpart or other popular constrained models.
Forecast outlier
Asset allocation

1. Introduction (2014) (PTV hereafter) imposes reasonable bounds on the conditional

Stock return forecasts play a central role in many financial areas
such as asset pricing, asset allocation, and risk management. However,
the seminal work by Welch and Goyal (2008) argue that it remains
difficult to find reliable models that can accurately predict stock returns
out-of-sample. To this end, a growing number of studies have con-
structed or used many powerful predictors and variables, which include
the variance risk premium (Bollerslev, Marrone, Xu, & Zhou, 2014;
Bollerslev, Tauchen, & Zhou, 2009), technical indicators (Gao, Han, Li,
& Zhou, 2018; Lin, 2018; Neely, Rapach, Tu, & Zhou, 2014; Zhang, Ma,
& Zhu, 2019), downside variance risk (Feunou, Jahan-Parvar, & Okou,
2015; Kilic & Shaliastovich, 2018), oil-related variables (Chiang &
Hughen, 2017; Liu, Ma, & Wang, 2015; Nonejad, 2018), short interest
index (Rapach, Ringgenberg, & Zhou, 2016), investor sentiment
(Huang, Jiang, Tu, & Zhou, 2015), news-implied volatility (Manela &
Moreira, 2017), economic policy uncertainty (Chen, Jiang, & Tong,
2017) and manager sentiment (Jiang, Lee, Martin, & Zhou, 2017),
among others.
On the other hand, a few articles attempt to improve return pre-
dictability from an economic constraint perspective. Campbell and
Thompson (2008) (CT hereafter) truncate the stock return forecasts at
zero and also constrain the sign of the regression slopes in predictive
regression models. Another influential paper by Pettenuzzo et al.
Sharpe ratio, which depends on both the conditional mean and vola-
tility of the return distribution, to lie between zero and one. Along the
same lines, we propose a new approach to impose economic constraints
on the time-series forecasts of stock return.
A rational investor is unlikely to rely on extremely positive or ne-
gative stock return forecasts to trade stocks. There are two economic
driving forces behind it. First, the possibility is too low when an ex-
tremely large or small forecast occurs in the future. Therefore, investors
will not trust the extreme values. Second, investors are typically risk-
averse, while the extremely positive or negative return forecasts make
their portfolio allocation too aggressive and thus amplify risk.
To some extent, our motivation is similar to that of Pettenuzzo et al.
(2014). They present that the conditional Sharpe ratio should be re-
stricted to lie between a lower and upper bound, which makes the
portfolio performance more reasonable. Pettenuzzo et al. (2014) pro-
pose a Bayesian approach to realize the bounds on the conditional
Sharpe ratio, while we use a straightforward but efficient method to
smooth forecast outliers. More specifically, we use the well-known
three-sigma rule to recognize the extremely positive or negative stock
return forecasts (i.e., forecast outliers) and smooth the return forecasts
by truncating them at the extreme values.
We first investigate the return predictability of our new economic
constraint based on univariate regression models, in which 14 popular

⁎
Corresponding author at: School of Finance, Yunnan University of Finance and Economics, 237 Longquan Road, Kunming, Yunnan, China.
E-mail addresses: weiyusy@126.com (Y. Wei), mafeng2016@swjtu.edu.cn (F. Ma).

https://doi.org/10.1016/j.irfa.2019.02.007
Received 17 November 2018; Received in revised form 17 January 2019; Accepted 22 February 2019
Available online 26 February 2019
1057-5219/ © 2019 Elsevier Inc. All rights reserved.
Y. Zhang, et al.
economic variables recommended by Welch and Goyal (2008) are used.
The empirical results show that our new constraint approach generates
larger out-of-sample R-squares (ROS2s) than the unconstrained coun-
terpart for all the 14 univariate regression models. Furthermore, we
make a comparison of our new constraint model and the popular CT
and PTV constraint models and find empirical evidence that our new
constraint model can beat the popular CT and PTV constraint models
for most of the univariate regression models.
Next, we further consider a few multivariate models, including a
diffusion index-based regression model and five widely used combina-
tion approaches from Rapach, Strauss, and Zhou (2010). The corre-
sponding results suggest that the multivariate models exhibit overall
stronger forecasting performance than the univariate regression
models. More importantly, the multivariate models subject to our new
constraint yield larger ROS2s than not only the unconstrained counter-
parts but also the CT and PTV constrained counterparts.
Finally, we measure the economic value of our new economic
constraint's predictive ability from an asset allocation perspective.
Specifically, we calculate the certainty equivalent return (CER) for a
mean-variance investor who allocates between stocks and risk-free bills
using various forecasts of stock return. The CER gain is calculated for
each model relative to the simple mean benchmark. We find that a
mean-variance investor can realize the largest CER gains when she uses
the return forecasts based on our new constraint approach to guide her
portfolio allocation.
Furthermore, our empirical results are robust to alternative eva-
luation techniques, business cycles, various risk aversion coefficients,
and the consideration of transaction cost. In summary, we propose a
new economic constraint approach, which is simple but efficient. The
new constraint approach is documented to outperform not only the
unconstrained approach but also the prevailing CT and PTV constraint
approaches via a comprehensive investigation.
Apparently, this paper is related to the works of Campbell and
Thompson (2008) and Pettenuzzo et al. (2014). A common feature of
the CT and PTV constraints is that they both rule out negative return
forecasts. However, the short-selling constraint on stocks is fading
away. A stock investor can easily take a short position when she pre-
dicts a negative stock return in the future. For this consideration, our
new economic constraint does not arbitrarily rule out the negative stock
return forecasts. We just do not trust extremely negative return fore-
casts (as well as extremely positive forecasts) because an extreme
forecast will hardly occur in the future and the corresponding portfolio
will be extremely risky. Due to this potential economic source, we find
that the new constraint approach outperforms CT and PTV constraint
approaches from both statistical and economic perspectives. Therefore,
this paper contributes to the literature on economic constraints and
stock return predictability.
The remainder of the paper is organized as follows. Section 2 de-
scribes our data. Section 3 introduces the forecasting strategies of
various economic constraints. Section 4 reports the empirical results
from both statistical and economic perspectives. Section 5 makes some
robustness checks. Section 6 concludes.
2. Data
In this paper, we investigate the monthly stock return predictability
based on 14 prevailing predictors originally analyzed in Welch and
Goyal (2008).1 The data sample is extended to 2017.2 Therefore, the
1
Numerous related studies also rely on these predictors to explore the pre-
dictability of stock returns. See Rapach et al. (2010), Zhu and Zhu (2013), Neely
et al. (2014), Pettenuzzo et al. (2014), Li and Tsiakas (2017), and Wang et al.
(2018a) for example.
2 3
Updated data for the variables in Welch and Goyal (2008) are available from
Amit Goyal's webpage at http://www.hec.unil.ch/agoyal/. We are grateful to
2
International Review of Financial Analysis 63 (2019) 1–9
whole sample period is from 1927:01 to 2017:12. The first 20 years are
used as the initial estimation period, so that the out-of-sample evalua-
tion period is from 1947:01 to 2017:12.
The excess stock return is computed as the monthly return on the S&
P 500 index (including dividends) minus the risk-free rate. In addition,
the 14 predictors are monthly economic fundamentals and their de-
scriptions are as follows.
1. Log dividend-price ratio (DP): log of a 12-month moving sum of
dividends paid on the S&P 500 index minus the log of stock prices
(S&P 500 index).
2. Log dividend yield (DY): log of a 12-month moving sum of divi-
dends minus the log of lagged stock prices.
3. Log earnings-price ratio (EP): log of a 12-month moving sum of
earnings on the S&P 500 index minus the log of stock prices.
4. Log dividend-payout ratio (DE): log of a 12-month moving sum of
dividends minus the log of a 12-month moving sum of earnings.
5. Stock return variance (SVAR): sum of squared daily returns on the S
&P 500 index.
6. Book-to-market ratio (BM): book-to-market value ratio for the Dow
Jones Industrial Average.
7. Net equity expansion (NTIS): ratio of a 12-month moving sum of
net equity issues by NYSE-listed stocks to the total end-of-year
market capitalization of NYSE stocks.
8. Treasury bill rate (TBL): interest rate on a three-month Treasury bill
(secondary market).
9. Long-term yield (LTY): long-term government bond yield.
10. Long-term return (LTR): return on long-term government bonds.
11. Term spread (TMS): long-term yield minus the Treasury bill rate.
12. Default yield spread (DFY): difference between Moody's BAA- and
AAA-rated corporate bond yields.
13. Default return spread (DFR): long-term corporate bond return
minus the long-term government bond return.
14. Inflation (INFL): calculated from the Consumer Price Index (CPI)
for all urban consumers.3
Table 1 provides the summary statistics for stock return and the 14
predictors. On average, the monthly excess stock return reaches
0.509%, which is quite appealing. Also, the monthly excess stock return
has a standard deviation of 5.423%, resulting in a monthly Sharpe ratio
of 0.094. In addition, the first-order autocorrelation of the excess stock
return is as low as 0.086, suggesting that stock return is very difficult to
be explained or predicted by its past. While the excess stock return has
little autocorrelation, most of the 14 predictors are highly persistent.
Overall, the summary statistics are generally consistent with the related
literature on stock return predictability (see, e.g., Huang et al., 2015).
3. Forecasting strategies
3.1. Univariate predictive regression model
We follow the convention in the literature on stock return predict-
ability and begin with a univariate predictive regression model as fol-
lows.
rt + 1 = i + i x i, t + i, t + 1, (1)
where rt+1 denotes the excess stock return for month t + 1, xi,t is the ith
predictor available at month t, and εi, t+1 is an error term with mean
equal to zero.
To generate out-of-sample forecasts of excess stock return, we use a
(footnote continued)
Amit Goyal for providing the data.
We lag inflation for an extra month to account for the delay in releases of the
CPI.
Y. Zhang, et al. International Review of Financial Analysis 63 (2019) 1–9

Table 1
Summary statistics.
Variable Mean Std. Dev. Min. Median Max. Skewness Kurtosis ρ(1)

Ret (%) 0.509 5.423 −33.927 0.953 34.553 −0.433 7.961 0.086
DP −3.373 0.462 −4.524 −3.348 −1.873 −0.218 −0.343 0.992
DY −3.368 0.459 −4.531 −3.341 −1.913 −0.246 −0.363 0.992
EP −2.738 0.417 −4.836 −2.790 −1.775 −0.602 2.620 0.986
DE −0.635 0.329 −1.244 −0.627 1.380 1.516 6.031 0.991
SVAR (%) 0.286 0.575 0.007 0.126 7.095 5.794 43.652 0.633
BM 0.568 0.266 0.121 0.542 2.028 0.779 1.464 0.985
NTIS 0.017 0.026 −0.058 0.017 0.177 1.651 8.247 0.979
TBL (%) 3.404 3.099 0.010 2.960 16.300 1.078 1.282 0.993
LTY (%) 5.124 2.792 1.750 4.225 14.820 1.085 0.603 0.996
LTR (%) 0.477 2.438 −11.240 0.313 15.230 0.589 4.689 0.043
TMS (%) 1.719 1.304 −3.650 1.770 4.550 −0.286 0.165 0.961
DFY (%) 1.126 0.693 0.320 0.900 5.640 2.481 8.870 0.975
DFR (%) 0.037 1.360 −9.750 0.050 7.370 −0.387 7.790 −0.120
INFL (%) 0.243 0.533 −2.055 0.242 5.882 1.078 13.818 0.481

This table provides the summary statistics for the excess stock return (Ret), the log dividend-price ratio (DP), log dividend yield (DY), log earnings-price ratio (EP),
log dividend payout ratio (DE), stock return variance (SVAR), book-to-market ratio (BM), net equity expansion (NTIS), Treasury bill rate (TBL), long-term bond yield
(LTY), long-term bond return (LTR), term spread (TMS), default yield spread (DFY), default return spread (DFR), and inflation rate (INFL). ρ(1) refers to the first-
order autocorrelation. The sample period is from 1927:01 to 2017:12.

recursive (expanding) estimation window, as in Rapach et al. (2010), 12 ( PTV

+
PTV
x i, )
i, i,
Neely et al. (2014), and Rapach et al. (2016), among others. Specifi- 0 1, = 1, …, t ,
(5)
cally, we divide the entire sample consisting of T observations into an
in-sample portion consisting of the first m observations and an out-of- where and
PTV PTV
are the coefficient estimates imposed by the PTV
i, i,
sample portion consisting of the last q observations. Then, the first out- constraint, and is the empirical estimate of stock volatility at month
of-sample forecast based on the ith predictor can be obtained by τ. Accordingly, the PTV forecasts are computed as
ri, m + 1 = i, m + i, m x i, m , (2) r iPTV PTV PTV
,t+1 = i, t + i, t x i, t , (6)
where ri, m + 1 is the stock return forecast at month m + 1 based on the ith
where r iPTV is the PTV forecast at month t + 1 based on the ith pre-
predictor, i, m and i, m are the ordinary least squares (OLS) estimates of
,t+1
dictor.
regression slopes in (1) generated by regressing {rt}t=2m on a constant
and {xi, t}t=1m−1. The next (second) out-of-sample forecast is calculated
as 3.3. A new economic constraint model

ri, m + 2 = i, m + 1 + i, m + 1 x i, m + 1, (3) In this paper, we propose a new economic constraint model, in

m+1 which the forecast outliers are smoothed. This is because a rational
where i, m + 1 and i, m + 1 are estimated by regressing {rt}t=2 on a
investor is unlikely to trust an extremely large or small forecast. Similar
constant and {xi, t}t=1m. Proceeding in this manner through the end of
to the PTV constraint, our constraint approach bounds the return
the out-of-sample period, we can obtain a series of q out-of-sample
forecasts within a rational range. Specifically, we employ the well-
forecasts of stock return, { ri, t }Tt = m + 1.
known three-sigma rule5 and smooth the return forecasts as

3.2. Existing economic constraint models ri, t + 3 t , if ri, t + 1 > ri, t + 3 t

r iNew
, t + 1 = ri, t 3 t , if ri, t + 1 < ri, t 3 t
In this paper, we consider two widely used economic constraints
ri, t + 1, otherwise, (7)
models as competing strategies relative to our new economic constraint.
The first is form Campbell and Thompson (2008). They propose an where is our new constraint forecast at month t + 1 based on the
r iNew
,t+1
economic constraint that a rational investor will rule out a negative ith predictor, ri, t + 1 is the original forecast generated by the regression
stock return forecast and therefore set the forecast to zero whenever it is model in (1), and σt is the standard deviation of excess stock returns for
negative.4 Statistically, the CT forecasts are given by month t.6
It is important to note that our new economic constraint approach
r iCT
, t + 1 = max (0, i, t + i , t x i, t ) , (4)
relies on the three-sigma deviation and does not consider other devia-
where is the CT forecast at month t + 1 based on the ith predictor.
r iCT
,t+1 tions. On one hand, the two-sigma deviation is not extremely large and
The second is from Pettenuzzo et al. (2014). They propose a Sharpe is thus likely to happen in the future. Therefore, it is not rational for an
ratio constraint approach that bounds the in-sample annualized Sharpe investor to rule out the two-sigma deviation. On the other hand, the
ratios between zero and one. More specifically, in the PTV constraint four-sigma (or even larger) deviation is too extreme to happen in the
approach, we estimate the regression slopes in Eq. (1) via constrained future, which leads our economic constraint to have no binding effect.
least squares, Considering these important facts, we only rely on the prevailing three-
sigma rule to perform our new economic constraint.
4
In addition to the non-negative forecast constraint, Campbell and Thompson
5
(2008) also constrain the sign of the regression slopes in predictive regression Note that we rely on the last stock return other than the simple mean in the
models. In this study, we do not consider the constraint on the sign of the re- three-sigma rule.
6
gression slopes, so that our focus is all on the constraint of return forecasts. Of We use a recursive estimation window to calculate the standard deviation of
course, the results are qualitatively similar when we further include the slope excess stock returns. The results are qualitatively similar when we rely on a
constraint. five-year rolling window.

3
Y. Zhang, et al. International Review of Financial Analysis 63 (2019) 1–9

4. Empirical results Table 2

Out-of-sample R-squares.
4.1. Out-of-sample forecasting performance Predictor Original CT PTV New

Following the convention in return forecasting (see, e.g., Rapach DP −0.117* 0.054* −0.123 0.619**
DY −0.445* 0.039** −0.120 0.204**
et al., 2010; Neely et al., 2014; Huang et al., 2015; Rapach et al., 2016;
EP −1.526* −0.628** −0.001 −0.848**
Jiang et al., 2017; Lin, Wu, & Zhou, 2018; Zhang, Ma, & Zhu, 2019; DE −1.466 −1.213 0.113 −0.691
Zhang, Zeng, Ma, & Shi, 2019), we use the out-of-sample R2 statistic SVAR 0.157 0.077 −0.215 0.847
advocated by Campbell and Thompson (2008) to evaluate the out-of- BM −1.551 −1.075 −0.202 −0.875
sample predictive accuracy of the model relative to the popular mean NTIS −0.526 −0.525 0.211* 0.433*
TBL 0.085* 0.271* 0.304* 0.873**
benchmark. The out-of-sample R2 statistic is defined as
LTY −0.665* 0.294** 0.069* 0.091**
q LTR −0.778 −0.651 0.127 0.077
(rm + k rm + k ) 2
2
ROS =1 k=1
, TMS 0.089 0.085 0.411** 0.992**
q
k=1
(rm + k rm + k )2 (8) DFY −0.173 −0.173 0.052 0.639
DFR −0.241 −0.423 0.002 0.504
where rm+k, rm + k , and rm + k are the actual stock return, historical INFL −0.057 −0.036 −0.004 0.741
average, and return forecast, respectively, at month m + k, and m and q Average −0.515 −0.279 0.045 0.257
are the length of initial estimation period and forecast evaluation
period, respectively. In particular, the historical average is computed as This table reports the out-of-sample R-square (R2OS) for univariate predictive
regressions based on 14 popular predictors. Original refers to the original
t
1 forecasts without economic constraints, while CT, PTV, and New correspond to
rt = ri. the Campbell and Thompson (2008) constraint approach, the Sharpe ratio
t i=1 (9)
constraint approach of Pettenuzzo et al. (2014), and our new economic con-
Fig. 1 plot the time series of the actual stock return and historical straint approach, respectively. Also reported are averages across all predictor
average benchmark over the out-of-sample period. The historical variables. Bold figures highlight instances in which the constrained R2OS is
higher than its unconstrained counterpart. Statistical significance for the R2OS
average is always positive and exhibits a stable trend during the out-of-
statistic is derived by using the Clark and West (2007) test. ***, **, and * in-
sample period, while the actual stock return fluctuates greatly. Al-
dicate significance at the 1%, 5%, and 10% levels, respectively. The initial
though the simple mean cannot match the actual stock return, this estimation period is 1927:01-1946:12, while the out-of-sample period is
benchmark is found to be difficult to be outperformed (see, e.g., 1947:01-2017:12.
Campbell & Thompson, 2008; Welch & Goyal, 2008). Hence, it is very
necessary to use a more reliable forecasting model to predict future on the forecasting model of interest, respectively. By regressing
stock returns. {fs}s=m+1T on a constant, we can conveniently derive the Clark and
The ROS2 statistic measures the reduction in mean squared forecast West (2007) statistic, which is just the t-statistic of the constant.
error (MSFE) for the forecasting model of interest relative to the pre- Moreover, a p-value for the one-sided (upper-tail) test is derived with
vailing historical average. To further ascertain whether the forecasting the standard normal distribution.
model yields a statistically significant improvement in MSFE, the Clark Table 2 reports the out-of-sample R2s for univariate predictive re-
and West (2007) statistic is employed. More specifically, the Clark and gressions subject to different economic constraints. When we use the CT
West (2007) statistic tests the null hypothesis that the MSFE of the and PTV constraints, 10 and 12, respectively, out of the 14 predictors
historical average benchmark is smaller than or equal to the MSFE of generate larger ROS2s than the unconstrained counterparts. Surpris-
the forecasting model of interest against the alternative hypothesis that ingly, our new constraint approach yields larger ROS2s than the un-
the MSFE of the historical average benchmark is larger than the MSFE constrained counterparts for all of the 14 predictors. Moreover, 11 of
of the forecasting model of interest. Mathematically, the Clark and West them are positive. On average, the CT and PTV constrained forecasts
(2007) statistic is computed by first defining generate larger ROS2s than the original unconstrained forecasts, while
our new approach yields the largest value of average ROS2 at 0.257%.
ft = (rt rt )2 (rt rt ) 2 + (rt rt )2 , (10)
Therefore, we can conclude that our new constraint approach of
where rt, rt , and rt are the actual stock return, the simple mean smoothing forecast outliers shows better out-of-sample forecasting
benchmark forecast of stock return, and the stock return forecast based performance than not only the original models without economic

Fig. 1. Actual stock returns and historical average over the out-of-sample period. The out-of-sample period is from 1947:01 to 2017:12. Vertical bars depict NBER-
dated recessions.

4
Y. Zhang, et al. International Review of Financial Analysis 63 (2019) 1–9

constraints but also the famous CT and PTV constraint approaches. Table 3
Multivariate results.
4.2. Multivariate results Forecasting model Original CT PTV New

Diffusion index 0.250** 0.291** 0.217** 1.136**

So far, we follow much of the literature on stock return predict-
Mean 0.513*** 0.424** 0.117 1.283**
ability and focus on univariate regression models. We next extend the Median 0.401*** 0.401** 0.145 1.157*
analysis to a multivariate setting. Specifically, we follow Pettenuzzo Trimmed mean 0.472*** 0.432** 0.127 1.268**
et al. (2014) and provide two strands of multivariate forecasting DMSPE(1) 0.500*** 0.412** 0.117 1.270**
models. The first strand is using principal component analysis (PCA) to DMSPE(0.9) 0.539*** 0.441** 0.120 1.306**

construct a common factor, which is the so-called diffusion index. We

then regress stock returns on a constant and the diffusion index as
follows.
rt + 1 = DI + DI FDI , t + i, t + 1,
where FDI, t is the diffusion index that is computed as the first principal
component of all the 14 predictors, which are standardized to have zero
mean and unit variance. To avoid the look-ahead bias, for each one-
step-ahead forecast, we only use the data available up to t to generate
the diffusion index for forecasting stock return at t + 1, and the pro-
cedure is repeated throughout the entire out-of-sample forecasting
period. Note that we follow Rapach et al. (2010) and Pettenuzzo et al.
(2014), and restrict our analysis to considering a single factor (i.e., the
first principal component). This is because the out-of-sample fore-
casting performance does not appear to improve if we include two or
more factors in Eq. (11).
The second strand is forecast combination. Rapach et al. (2010)
document that forecast combination can reduce the forecast variance
and thus generate more reliable stock return forecasts. Statistically,
combination forecasts are computed as weighted averages of the N
(N = 14) individual forecasts, which is given by
N new economic constraint can avoid forecast outliers when using com-
rc, t + 1 = i, t ri, t + 1,
i=1
This table reports the out-of-sample R-square (R2OS) for multivariate models. The
diffusion index constructed by the principal component analysis based on the
14 predictors. Five popular combination approaches include the mean, median,
trimmed mean, DMSPE(1), and DMSPE(0.9), which combine the 14 individual
(11)
forecasts. Original refers to the original forecasts without economic constraints,
while CT, PTV, and New correspond to the Campbell and Thompson (2008)
constraint approach, the Sharpe ratio constraint approach of Pettenuzzo et al.
(2014), and our new economic constraint approach, respectively. Bold figures
highlight instances in which the constrained R2OS is higher than its un-
constrained counterpart. Statistical significance for the R2OS statistic is derived
by using the Clark and West (2007) test. ***, **, and * indicate significance at
the 1%, 5%, and 10% levels, respectively. The initial estimation period is
1927:01-1946:12, while the out-of-sample period is 1947:01-2017:12.
among the different constraint approaches. In other words, our new
economic constraint of smoothing forecast outliers exhibits better
forecasting performance in a multivariate setting.
In particular, forecast combination can substantially reduce forecast
variance, thus generating relatively reliable forecasts (see, e.g., Rapach
et al., 2010). However, our results suggest that the combination fore-
casts based on the original individual forecasts still have extreme value.
Furthermore, the superior out-of-sample performance indicates that our
bination strategy.
(12)

where rc, t + 1 is the combination forecast at month t + 1, ri, t + 1 is the ith
individual forecast, and ωi, t represents the combining weight of the ith
individual forecast calculated at month t.
Following Pettenuzzo et al. (2014), we consider five popular com-
bination approaches recommended by Rapach et al. (2010): mean,
median, trimmed mean, DMSPE(1), and DMSPE(0.9). The mean com-
bination forecast takes the mean of the N individual forecasts, { ri, t + 1 }iN= 1.
The median combination forecast takes the median of { ri, t + 1 }iN= 1. The
trimmed mean combination forecast discards the smallest and largest
individual forecasts in { ri, t + 1 }iN= 1 and sets ωi, t = 1/(N − 2) for the re-
mainder of the individual forecasts. In the discount mean squared
prediction error (DMSPE) combining method, the combining weights of
the ith individual forecast at month t are expressed as
= 1
/
N 1
i, t i, t ,t , (13)
=1
4.3. Asset allocation
Following a large body of related literature on stock return pre-
dictability,7 we further measure the economic value of various stock
return forecasts from an asset allocation perspective. More specifically,
we calculate the certainty equivalent return (CER) for a mean-variance
investor who allocates between stocks and risk-free bills using various
forecasts of stock returns. In order to achieve the maximum CER, the
investor would allocate the weight of stocks during month t + 1 as
wt =
1 rt + 1
,
2
t+1 (15)
where γ is the investor's risk aversion coefficient, rt + 1 denotes a return
forecast, and t2+ 1 denotes a forecast of the stock return variance. As in
Campbell and Thompson (2008), Rapach et al. (2010), Neely et al.

where
t
t s (r ri, s )2 ,
i, t =
s=m+1
s (14)
m is the length of the initial training sample period and θ is a discount
factor. Following Rapach et al. (2010), Zhu and Zhu (2013), and Zhang,
Ma, Shi, and Huang (2018), we consider two values of θ, namely, 1 and
0.9. Consequently, two DMSPE methods, DMSPE(1) and DMSPE(0.9),
are used in this study.
Table 3 reports the ROS2s for the multivariate models. Two ob-
servations follow the table immediately. First, the multivariate fore-
casting models using all the information from the 14 predictors yield
larger ROS2s than the univariate regression models. The better out-of-
sample forecasting performance of the multivariate models is consistent
with the previous literature on return predictability (see, e.g., Rapach
et al., 2010; Zhu & Zhu, 2013; Neely et al., 2014). Second and more
importantly, our new constraint approach yields the largest ROS2s
(2014), and Jiang et al. (2017), among others, we estimate the variance
forecasts using a five-year moving window of past stock returns.8 In
addition, we restrict wt to the range between −0.5 and 1.5 to allow no
more than 50% leverage.9
7
See, for example, Campbell and Thompson (2008), Rapach et al. (2010),
Neely et al. (2014), Phan, Sharma, and Narayan (2015), Rapach et al. (2016),
Jiang et al. (2017), and Wang, Qian, and Wang (2018).
8
Alternatively, Rapach et al. (2016) uses a ten-year moving window to es-
timate the return volatility. The economic value results are qualitatively similar
for a ten-year moving window. To save space, we do not report these results,
but they are available upon request.
9
More studies restrict the portfolio weight to lie between 0 and 1.5; see, e.g.,
Campbell and Thompson (2008), Rapach et al. (2010), Neely et al. (2014),
Huang et al. (2015), and Jiang et al. (2017). However, we follow Rapach et al.
(2016) and use the weight range between −0.5 and 1.5. This is because if we
restrict the portfolio weight to the range between 0 and 1.5, the portfolio

5
Y. Zhang, et al. International Review of Financial Analysis 63 (2019) 1–9

Table 4 5. Robustness checks

Portfolio performance.
Forecasting model Original CT PTV New 5.1. Alternative evaluation techniques

DP −1.829 −1.236 −1.067 −1.609 Although the ROS2 statistic and Clark and West (2007) test are the
DY −2.137 −1.292 −1.106 −2.080
conventions in examining the stock return predictability, a few articles
EP 0.418 0.540 −0.485 0.548
DE −0.274 −0.210 −0.199 0.090
rely on other statistical evaluation techniques. For example, Charles,
SVAR −0.205 −0.205 −0.802 0.266 Darné, and Kim (2017) and Nonejad (2018) both use the model con-
BM −2.407 −1.642 −1.345 −2.342 fidence set (MCS) to assess the out-of-sample forecasting performance
NTIS 0.538 0.538 −0.366 0.980 of stock returns. Given this, we also use the MCS test to check the
TBL 1.518 1.500 0.287 1.827
economic constraint approaches.
LTY 0.630 0.972 −0.389 0.923
LTR 0.435 0.434 0.303 0.773 The MCS test is originally proposed by Hansen, Lunde, and Nason
TMS 1.570 1.578 0.523 2.044 (2011). This test can ascertain whether the forecasting models have a
DFY −0.395 −0.366 −0.931 −0.036 statistically significant difference in the out-of-sample performance
DFR 0.471 0.404 −1.019 0.760
without specifying a benchmark model. A MCS is a subset of models
INFL 0.236 0.276 −0.456 0.577
Diffusion index 0.230 0.150 −0.658 0.699
that contains the best model with a given level of confidence. The in-
Mean 0.870 0.425 −0.562 1.260 terpretation of a MCS p-value is analogous to that of a classical p-value
Median 0.669 0.669 −0.207 1.007 (Hansen et al., 2011). It is evident that a model with a larger MCS p-
Trimmed mean 0.805 0.516 −0.340 1.163 value shows stronger predictive ability. Following Hansen et al. (2011)
DMSPE(1) 0.884 0.435 −0.561 1.275
and Ma, Li, Liu, and Zhang (2018), among others, we consider the
DMSPE(0.9) 0.992 0.511 −0.543 1.383
significance (confidence) level of 25% (75%). That is, a forecasting
This table reports the certainty equivalent return (CER) gains. Original refers to model will be included in the MCS when its MCS p-value is larger than
the original forecasts without economic constraints, while CT, PTV, and New 0.25. The excluded models are viewed as significantly inferior models.
correspond to the Campbell and Thompson (2008) constraint approach, the In particular, all of the MCS p-values reported in this paper is calculated
Sharpe ratio constraint approach of Pettenuzzo et al. (2014), and our new based on the range statistic using the circular block bootstrap.10
economic constraint approach, respectively. The annualized CER is calculated In this study, the MCS test is based on two popular loss functions,
based on a mean-variance investor with relative risk aversion coefficient of namely, mean squared error (MSE) and mean absolute error (MAE).11
three who allocates between stocks and risk-free bills using the return forecasts
Table 5 provides the mean values of the two loss functions and the cor-
from various forecasting models. The CER gain is calculated as the difference
responding MCS p-values. In Panel A of Table 5, we find that our new
between the CER for the investor when she uses return forecasts and the CER
when she uses the prevailing mean benchmark. Bold figures highlight instances
constraint approach yields lower forecast error including both MSE and
in which the constrained CER gain is higher than its unconstrained counterpart. MAE than the unconstrained counterparts for all the used forecasting
The initial estimation period is 1927:01-1946:12, while the out-of-sample models. This is consistent with the evidence from the ROS2 statistic.
period is 1947:01-2017:12. We report the MCS p-values in Panel B of Table 5. While there is no
statistically significant difference among the four economic constraint
For a portfolio constructed by Eq. (15), the investor can realize an approaches for some forecasting models, the overall forecasting per-
average CER as formance of our new economic constraint is the best. Specifically, when
we depend on the loss function of MSE, only our new constraint ap-
CER = Rp 0.5 2
p, (16) proach can fall into the MCS with the 75% confidence level for all the
20 forecasting models (including 14 univariate models and 6 multi-
where Rp and σp2 denote the mean and variance, respectively, of the variate models). Furthermore, our new constraint approach yields the
realized portfolio returns during the out-of-sample evaluation period. largest MCS p-value of 1 for most of the forecasting models. In terms of
The CER gain is calculated as the difference between the CER for the MAE, only one model based on our new economic constraint does not
investor when she uses return forecasts and the CER when she uses the enter the MCS with the 75% confidence level. In contrast, the un-
prevailing mean benchmark. Accordingly, the CER gain can be regarded constrained approach as well as the CT and PTV constrained ap-
as the portfolio management fee that a mean-variance investor would proaches have more forecasting models that cannot enter the MCS. In
be willing to pay to have access to the return forecasts in instead of the addition, our new constraint approach yields the largest MCS p-value of
historical average forecasts. 1 for 17 out of the 20 forecasting models based on MAE, while the CT
Table 4 reports the CER gains for all the forecasting models subject and PTV approaches only have 1 and 2, respectively, models that yield
to different economic constraints. Compared with the original fore- the largest MCS p-value of 1.
casting models without economic constraints, the forecasting models In summary, compared to the ROS2 statistic and Clark and West (2007)
subject to the CT and PTV constraints do not enhance the CER gains test, the MCS test based on MSE and MAE produces robust results. That is,
obviously. Fortunately, all of the forecasting models based on our new the new constraint approach outperforms not only the original version
constraint approach yield larger CER gains than the original ones and but also the prevailing CT and PTV constrained versions.
most of the ones based on the CT and PTV constraints. Furthermore, all
the multivariate forecasting models subject to our new constraint gen-
5.2. Business cycles
erate considerably positive CER gains, all of which are larger than not
only the CT and PTV constrained counterparts but also the un-
While the overall ROS2 is interesting, it is also important to analyze
constrained counterparts. In conclusion, a mean-variance investor can
the return predictability during business cycles. Following related stu-
realize larger economic gains using our new constraint approach to
dies (see, e.g., Rapach et al., 2010; Neely et al., 2014; Huang et al.,
allocate her portfolio.

(footnote continued)
performance of the CT constraint method will reduce to that of the original
forecasting models without economic constraints.
10
We obtain qualitatively similar results of MCS p-values when using the
semi-quadratic statistic or the stationary bootstrap. To save space, we do not
report these results, but they are available upon request.
11
Note that the loss function of MSE is consistent with the out-of-sample R2,
which is calculated based on MSE.

6
Y. Zhang, et al. International Review of Financial Analysis 63 (2019) 1–9

Table 5
Out-of-sample performance using the MCS test.
Forecasting model MSE MAE

Original CT PTV New Original CT PTV New

Panel A: The mean value of loss functions

DP 0.171 0.171 0.171 0.170 3.180 3.173 3.170 3.169
DY 0.172 0.171 0.171 0.171 3.197 3.175 3.176 3.188
EP 0.174 0.172 0.171 0.172 3.200 3.177 3.169 3.190
DE 0.173 0.173 0.171 0.172 3.151 3.148 3.155 3.141
SVAR 0.171 0.171 0.171 0.169 3.140 3.140 3.160 3.130
BM 0.174 0.173 0.171 0.172 3.213 3.195 3.175 3.203
NTIS 0.172 0.172 0.171 0.170 3.133 3.133 3.154 3.120
TBL 0.171 0.170 0.170 0.169 3.134 3.136 3.156 3.123
LTY 0.172 0.170 0.171 0.171 3.154 3.147 3.165 3.143
LTR 0.172 0.172 0.171 0.171 3.170 3.165 3.160 3.158
TMS 0.171 0.171 0.170 0.169 3.136 3.135 3.148 3.124
DFY 0.171 0.171 0.171 0.170 3.147 3.147 3.151 3.135
DFR 0.171 0.172 0.171 0.170 3.150 3.150 3.160 3.139
INFL 0.171 0.171 0.171 0.170 3.139 3.139 3.159 3.128
Diffusion index 0.171 0.170 0.171 0.169 3.174 3.170 3.169 3.162
Mean 0.170 0.170 0.171 0.169 3.143 3.141 3.160 3.133
Median 0.170 0.170 0.171 0.169 3.140 3.140 3.157 3.129
Trimmed mean 0.170 0.170 0.171 0.169 3.145 3.143 3.160 3.133
DMSPE(1) 0.170 0.170 0.171 0.169 3.144 3.142 3.160 3.133
DMSPE(0.9) 0.170 0.170 0.171 0.169 3.143 3.141 3.160 3.132

Panel B: MCS p-values

DP 0.319* 0.508* 0.508* 1.000* 0.007 0.875* 0.943* 1.000*
DY 0.263* 0.871* 0.871* 1.000* 0.001 1.000* 0.884* 0.400*
EP 0.485* 0.737* 1.000* 0.737* 0.101 0.641* 1.000* 0.569*
DE 0.265* 0.276* 1.000* 0.460* 0.540* 0.704* 0.704* 1.000*
SVAR 0.427* 0.427* 0.427* 1.000* 0.402* 0.402* 0.058 1.000*
BM 0.103 0.359* 1.000* 0.485* 0.002 0.127 1.000* 0.127
NTIS 0.447* 0.447* 0.836* 1.000* 0.299* 0.299* 0.246 1.000*
TBL 0.501* 0.722* 0.722* 1.000* 0.357* 0.357* 0.034 1.000*
LTY 0.473* 1.000* 0.750* 0.833* 0.358* 0.840* 0.032 1.000*
LTR 0.367* 0.367* 1.000* 0.952* 0.111 0.763* 0.889* 1.000*
TMS 0.509* 0.509* 0.509* 1.000* 0.349* 0.349* 0.237 1.000*
DFY 0.351* 0.351* 0.383* 1.000* 0.242 0.242 0.242 1.000*
DFR 0.462* 0.462* 0.555* 1.000* 0.349* 0.349* 0.318* 1.000*
INFL 0.342* 0.426* 0.426* 1.000* 0.345* 0.345* 0.042 1.000*
Diffusion index 0.440* 0.440* 0.440* 1.000* 0.132 0.716* 0.716* 1.000*
Mean 0.292* 0.292* 0.203 1.000* 0.352* 0.363* 0.028 1.000*
Median 0.239 0.239 0.239 1.000* 0.121 0.121 0.041 1.000*
Trimmed mean 0.300* 0.300* 0.212 1.000* 0.282* 0.284* 0.042 1.000*
DMSPE(1) 0.301* 0.301* 0.206 1.000* 0.345* 0.364* 0.028 1.000*
DMSPE(0.9) 0.294* 0.294* 0.181 1.000* 0.353* 0.353* 0.025 1.000*

This table reports the mean values of the two loss functions of MSE and MAE in Panel A and the corresponding MCS p-values in Panel B. Original refers to the original
forecasts without economic constraints, while CT, PTV, and New correspond to the Campbell and Thompson (2008) constraint approach, the Sharpe ratio constraint
approach of Pettenuzzo et al. (2014), and our new economic constraint approach, respectively. Bold figures highlight instances in which the constrained value of MSE
or MAE is smaller than its unconstrained counterpart. *Highlights instances in which the MCS p-value is larger than 0.25. The initial estimation period is 1927:01-
1946:12, while the out-of-sample period is 1947:01-2017:12.

2015; Jiang et al., 2017; Ma, Liu, Wahab, & Zhang, 2018; Wang, Qian, new constraint approach is more effective in the forecasting of stock re-
& Wang, 2018), we compute the ROS2 statistic separately for expansions turns than the CT and PTV models for both expansions and recessions and
(ROS, EXP2) and recessions (ROS, REC2), our approach itself shows stronger forecasting performance during the
recession period than during the expansion period.
q
2 k=1
Imc + k (rm + k rm + k ) 2
ROS ,c = 1 q for c = EXP, REC,
k=1
Imc + k (rm + k rm + k ) 2 (17) 5.3. Alternative risk aversion coefficients

where Im+kEXP (Im+kREC) is an indicator that takes a value of one when
month m + k is in an NBER expansion (recession) period and zero
otherwise.
Table 6 reports the out-of-sample forecasting performance over
business cycles. Two important findings emerge. First, consistent with the
related literature on return predictability (see, e.g., Rapach et al., 2010;
Neely et al., 2014; Huang et al., 2015; Jiang et al., 2017), the return
predictability is concentrated over recessions for all the forecasting
models. Second and more importantly, for both the expansion and re-
cession periods, most of the forecasting models subject to our new con-
straint generate larger ROS2s than the ones subject to the CT and PTV
constraints as well as the unconstrained counterparts. In summary, our
In the asset allocation exercise above, we assume that a mean-var-
iance investor has a risk aversion coefficient of three. However, the
optimal portfolio weight given in Eq. (15) changes with the value of risk
aversion coefficient. For this consideration, we further consider other
different risk aversion coefficients and investigate the impact of risk
aversion coefficient on the portfolio performance.
Table 7 reports the CER gains for alternative risk aversion coeffi-
cients, including two, four, and six. Although the CER gains vary with
different risk aversion coefficients, all of the forecasting models based
on our new constraint approach yield larger CER gains than the original
ones. Furthermore, all the multivariate forecasting models subject to
our new constraint still produce considerably positive CER gains, which

7
Y. Zhang, et al. International Review of Financial Analysis 63 (2019) 1–9

Table 6
Out-of-sample performance over business cycles.
Forecasting model Expansions Recessions

Original CT PTV New Original CT PTV New

DP −0.800 −0.562 −0.762 −0.057 1.779** 1.764** 1.650*** 2.493**

DY −1.578 −0.886 −0.847 −0.925 2.696*** 2.608** 1.898*** 3.335***
EP −1.283* −0.508* −0.448 −0.524** −2.199 −0.960 1.241* −1.747
DE −1.042 −0.989 −0.273 −0.227 −2.641 −1.835 1.185** −1.979
SVAR −0.025 −0.042 −0.709 0.837 0.662 0.407 1.157** 0.872
BM −1.975 −1.321 −0.764 −1.270 −0.374 −0.394 1.355** 0.221
NTIS 0.624** 0.625** −0.175 1.483** −3.717 −3.717 1.282** −2.478
TBL −0.348 0.130 −0.276 0.409* 1.289 0.663 1.915** 2.160*
LTY −1.117 0.080* −0.628 −0.372* 0.587 0.889 2.000** 1.374
LTR −1.374 −1.200 −0.510 −0.434 0.877 0.873 1.896*** 1.495*
TMS −0.199 −0.224 0.001 0.693 0.888 0.941 1.550*** 1.822**
DFY −0.174 −0.174 −0.134 0.627 −0.172 −0.172 0.568* 0.673
DFR −0.117 −0.198 −0.453 0.646 −0.587 −1.048 1.265** 0.110
INFL 0.074 0.082 −0.474 0.861 −0.419 −0.362 1.302** 0.408
Diffusion index −0.808 −0.615 −0.555 0.076 3.183*** 2.804** 2.361*** 4.077***
Mean 0.378** 0.392** −0.384 1.168* 0.889** 0.511 1.507*** 1.601**
Median 0.324** 0.324** −0.330 1.098 0.615** 0.615** 1.463*** 1.320*
Trimmed mean 0.321* 0.328** −0.374 1.131* 0.888** 0.720** 1.515*** 1.648**
DMSPE(1) 0.362** 0.377** −0.385 1.153* 0.883** 0.508* 1.507*** 1.595**
DMSPE(0.9) 0.363** 0.375** −0.383 1.153* 1.027** 0.625* 1.514*** 1.729**

This table reports the out-of-sample R-square (R2OS) over business cycles. Original refers to the original forecasts without economic constraints, while CT, PTV, and
New correspond to the Campbell and Thompson (2008) constraint approach, the Sharpe ratio constraint approach of Pettenuzzo et al. (2014), and our new economic
constraint approach, respectively. Bold figures highlight instances in which the constrained R2OS is higher than its unconstrained counterpart. Statistical significance
for the R2OS statistic is derived by using the Clark and West (2007) test. ***, **, and * indicate significance at the 1%, 5%, and 10% levels, respectively. The initial
estimation period is 1927:01-1946:12, while the out-of-sample period is 1947:01-2017:12.

are larger than the other constrained and unconstrained counterparts.
The CER results are thus robust to alternative risk aversion coefficients.
5.4. Transaction cost
In the practical application, we need to pay transaction cost when
trading assets, which will influence the portfolio performance. Given
this, we follow Neely et al. (2014) and assume a proportional transac-
tion cost equal to 50 basis points per transaction. Table 8 reports the
CER gains net of transaction cost. Two observations follow the table.
First, as expected, all the CER gains are lower than the ones without
transaction cost. This is intuitive because the economic value is in-
versely related to the average monthly turnover and the historical
average benchmark always yields a very low turnover. As evidenced in

Table 7
Portfolio performance for alternative risk aversion coefficients.
Forecasting model Risk aversion coefficient is 2 Risk aversion coefficient is 4 Risk aversion coefficient is 6

Original CT PTV New Original CT PTV New Original CT PTV New

DP −2.957 −2.403 −1.925 −2.672 −1.064 −0.429 −0.556 −0.886 0.004 0.618 0.234 0.139
DY −3.641 −2.732 −1.988 −3.556 −1.368 −0.579 −0.586 −1.325 −0.304 0.540 0.214 −0.260
EP 0.243 0.445 −1.098 0.409 0.272 0.384 −0.119 0.383 0.177 0.335 0.527 0.268
DE −0.342 −0.277 −0.696 0.080 −0.270 −0.221 0.101 0.018 −0.587 −0.554 0.676 −0.377
SVAR −0.078 −0.078 −1.182 0.373 −0.337 −0.337 −0.739 0.154 −0.489 −0.489 −0.421 0.000
BM −3.080 −2.315 −2.149 −3.012 −2.161 −1.429 −0.743 −2.100 −1.816 −1.118 0.111 −1.759
NTIS 0.298 0.298 −0.619 0.750 −0.033 −0.033 −0.094 0.369 −0.223 −0.223 0.545 0.149
TBL 0.761 0.740 −0.030 1.092 1.270 1.258 0.518 1.572 1.020 1.069 0.952 1.263
LTY −0.045 0.277 −0.848 0.262 0.733 1.144 −0.047 0.986 0.642 1.129 0.574 0.827
LTR 0.355 0.367 0.297 0.709 0.102 0.092 0.493 0.436 −0.294 −0.309 0.934 −0.055
TMS 1.464 1.434 0.396 1.916 1.202 1.225 0.648 1.651 0.488 0.510 1.031 0.866
DFY −0.800 −0.757 −0.939 −0.394 −0.712 −0.690 −0.970 −0.374 −0.838 −0.823 −0.282 −0.513
DFR 0.215 0.127 −1.312 0.586 0.237 0.185 −0.724 0.468 0.141 0.102 −0.003 0.312
INFL −0.085 −0.027 −1.030 0.294 0.182 0.216 −0.082 0.508 0.083 0.106 0.552 0.322
Diffusion index −0.434 −0.623 −1.270 0.015 0.168 0.247 −0.233 0.618 0.396 0.671 0.448 0.766
Mean 0.223 0.181 −0.725 0.675 0.829 0.541 −0.176 1.154 1.014 0.757 0.489 1.247
Median 0.225 0.225 −0.565 0.600 0.606 0.606 0.107 0.882 0.708 0.708 0.678 0.908
Trimmed mean 0.351 0.242 −0.607 0.754 0.763 0.591 −0.007 1.058 1.028 0.913 0.602 1.241
DMSPE(1) 0.227 0.178 −0.725 0.680 0.824 0.535 −0.175 1.150 1.008 0.752 0.490 1.241
DMSPE(0.9) 0.264 0.158 −0.715 0.721 0.956 0.603 −0.160 1.271 1.150 0.860 0.499 1.376

This table reports the certainty equivalent return (CER) gains for alternative risk aversion coefficients, including 2, 4, and 6. Original refers to the original forecasts
without economic constraints, while CT, PTV, and New correspond to the Campbell and Thompson (2008) constraint approach, the Sharpe ratio constraint approach
of Pettenuzzo et al. (2014), and our new economic constraint approach, respectively. The annualized CER is calculated based on a mean-variance investor who
allocates between stocks and risk-free bills using the return forecasts from various forecasting models. The CER gain is calculated as the difference between the CER
for the investor when she uses return forecasts and the CER when she uses the prevailing mean benchmark. Bold figures highlight instances in which the constrained
CER gain is higher than its unconstrained counterpart. The initial estimation period is 1927:01-1946:12, while the out-of-sample period is 1947:01-2017:12.

8
Y. Zhang, et al. International Review of Financial Analysis 63 (2019) 1–9

Table 8 acknowledges the support from the National Natural Science

Portfolio performance including transaction cost. Foundation of China [71371157, 71671145], the Humanities and
Forecasting model Original CT PTV New Social Science Fund of Ministry of Education of China [17YJA790015,
17XJA790002, 18YJC790132, 18XJA790002] and Key Laboratory of
DP −2.066 −1.413 −1.092 −1.867 Service Computing and Safety Management of Yunnan Provincial
DY −2.542 −1.463 −1.173 −2.492
Universities. Feng Ma acknowledges the support from the Natural
EP 0.132 0.321 −0.527 0.255
DE −0.308 −0.235 −0.193 0.015
Science Foundation of China [71701170], the Humanities and Social
SVAR −0.286 −0.286 −1.100 0.150 Science Fund of the Ministry of Education [17YJC790105,
BM −2.676 −1.810 −1.380 −2.614 17XJCZH002], and Fundamental research funds for the central uni-
NTIS 0.373 0.373 −0.353 0.762 versities [682017WCX01, 2682018WXTD05].
TBL 1.349 1.404 0.254 1.618
LTY 0.439 0.882 −0.445 0.694
LTR −1.243 −1.162 −0.539 −0.913 References
TMS 1.319 1.358 0.401 1.735
DFY −0.501 −0.465 −1.010 −0.188 Bollerslev, T., Marrone, J., Xu, L., & Zhou, H. (2014). Stock return predictability and variance
DFR −0.186 −0.226 −1.416 0.103 risk premia: Statistical inference and international evidence. Journal of Financial and
INFL −0.474 −0.412 −0.484 −0.177 Quantitative Analysis, 49, 633–661.
Diffusion index −0.104 −0.037 −0.716 0.351 Bollerslev, T., Tauchen, G., & Zhou, H. (2009). Expected stock returns and variance risk premia.
Review of Financial Studies, 22, 4463–4492.
Mean 0.733 0.329 −0.583 1.082
Campbell, J. Y., & Thompson, S. B. (2008). Predicting excess stock returns out of sample: Can
Median 0.519 0.519 −0.259 0.815 anything beat the historical average? Review of Financial Studies, 21, 1509–1531.
Trimmed mean 0.669 0.399 −0.356 0.984 Charles, A., Darné, O., & Kim, J. H. (2017). International stock return predictability: Evidence
DMSPE(1) 0.744 0.338 −0.582 1.095 from new statistical tests. International Review of Financial Analysis, 54, 97–113.
DMSPE(0.9) 0.832 0.405 −0.564 1.180 Chen, J., Jiang, F., & Tong, G. (2017). Economic policy uncertainty in China and stock market
expected returns. Accounting and Finance, 57, 1265–1286.
Chiang, I.-H. E., & Hughen, W. K. (2017). Do oil futures prices predict stock returns? Journal of
This table reports the certainty equivalent return (CER) gains when we assume Banking & Finance, 79, 129–141.
a proportional transaction cost of 50 basis points per transaction. Original refers Clark, T. E., & West, K. D. (2007). Approximately normal tests for equal predictive accuracy in
to the original forecasts without economic constraints, while CT, PTV, and New nested models. Journal of Econometrics, 138, 291–311.
Feunou, B., Jahan-Parvar, M. R., & Okou, C. (2015). Downside variance risk premium. Journal
correspond to the Campbell and Thompson (2008) constraint approach, the
of Financial Econometrics, 1–43.
Sharpe ratio constraint approach of Pettenuzzo et al. (2014), and our new Gao, L., Han, Y., Li, S. Z., & Zhou, G. (2018). Market intraday momentum. Journal of Financial
economic constraint approach, respectively. The annualized CER is calculated Economics, 129, 394–414.
based on a mean-variance investor with relative risk aversion coefficient of Hansen, P. R., Lunde, A., & Nason, J. M. (2011). The model confidence set. Econometrica, 79,
453–497.
three who allocates between stocks and risk-free bills using the return forecasts Huang, D., Jiang, F., Tu, J., & Zhou, G. (2015). Investor sentiment aligned: A powerful predictor
from various forecasting models. The CER gain is calculated as the difference of stock returns. Review of Financial Studies, 28, 791–837.
between the CER for the investor when she uses return forecasts and the CER Jiang, F., Lee, J. A., Martin, X., & Zhou, G. (2017). Manager sentiment and stock returns. Journal
of Financial Economics. https://doi.org/10.1016/j.jfineco.2018.10.001https://www.
when she uses the prevailing mean benchmark. Bold figures highlight instances sciencedirect.com/science/article/pii/S0304405X18302770 (forthcoming).
in which the constrained CER gain is higher than its unconstrained counterpart. Kilic, M., & Shaliastovich, I. (2018). Good and bad variance premia and expected returns.
The initial estimation period is 1927:01-1946:12, while the out-of-sample Management Science. https://doi.org/10.1287/mnsc.2017.2890https://pubsonline.
informs.org/doi/abs/10.1287/mnsc.2017.2890 (forthcoming).
period is 1947:01-2017:12.
Li, J., & Tsiakas, I. (2017). Equity premium prediction: The role of economic and statistical
constraints. Journal of Financial Markets, 36, 56–75.
Fig. 1, the historical average is very stable. However, the return fore- Lin, H., Wu, C., & Zhou, G. (2018). Forecasting corporate bond returns with a large set of
predictors: An iterated combination approach. Management Science, 64, 3971–4470.
casts generated by the forecasting models are relatively fluctuant, thus Lin, Q. (2018). Technical analysis and stock return predictability: An aligned approach. Journal
yielding a higher turnover. The higher turnover leads to higher trans- of Financial Markets, 38, 103–123.
Liu, L., Ma, F., & Wang, Y. (2015). Forecasting excess stock returns with crude oil market data.
action cost. The second observation is that the forecasting models based Energy Economics, 48, 316–324.
on our new constraint approach typically yield larger CER gains than Ma, F., Li, Y., Liu, L., & Zhang, Y. (2018). Are low-frequency data really uninformative? A
forecasting combination perspective. North American Journal of Economics and Finance, 44,
the other constrained and unconstrained models. The CER results are
92–108.
thus robust to the consideration of transaction cost. Ma, F., Liu, J., Wahab, M. I. M., & Zhang, Y. (2018). Forecasting the aggregate oil price vola-
tility in a data-rich environment. Economic Modelling, 72, 320–332.
Manela, A., & Moreira, A. (2017). News implied volatility and disaster concerns. Journal of
6. Conclusion Financial Economics, 123, 137–162.
Neely, C. J., Rapach, D. E., Tu, J., & Zhou, G. (2014). Forecasting the equity risk premium: The
role of technical indicators. Management Science, 60, 1772–1791.
In this paper, we propose a new economic constraint approach to Nonejad, N. (2018). Déjà vol oil? Predicting S&P 500 equity premium using crude oil price
predict stock returns. Since a rational investor does not trust extremely volatility: Evidence from old and recent time-series data. International Review of Financial
large and small return forecasts, we truncate the forecasts at the ex- Analysis, 58, 260–270.
Pettenuzzo, D., Timmermann, A., & Valkanov, R. (2014). Forecasting stock returns under
treme values. We compare the new constraint approach to two previous economic constraints. Journal of Financial Economics, 114, 517–553.
economic constraint approaches proposed by Campbell and Thompson Phan, D. H. B., Sharma, S. S., & Narayan, P. K. (2015). Stock return forecasting: Some new
evidence. International Review of Financial Analysis, 40, 38–51.
(2008) and Pettenuzzo et al. (2014). The out-of-sample results suggest Rapach, D. E., Ringgenberg, M. C., & Zhou, G. (2016). Short interest and aggregate stock re-
that our new constraint approach outperforms the prevailing CT and turns. Journal of Financial Economics, 121, 46–65.
Rapach, D. E., Strauss, J. K., & Zhou, G. (2010). Out-of-sample equity premium prediction:
PTV constraints as well as the original models without economic con-
Combination forecasts and links to the real economy. Review of Financial Studies, 23,
straints from both statistical and economic perspectives. The superiority 821–862.
of our new constraint is supported by not only the univariate regression Wang, Z., Qian, Y., & Wang, S. (2018). Dynamic trading volume and stock return relation: Does
it hold out of sample? International Review of Financial Analysis, 58, 195–210.
models but also more reliable multivariate models. Welch, I., & Goyal, A. (2008). A comprehensive look at the empirical performance of equity
premium prediction. Review of Financial Studies, 21, 1455–1508.
Zhang, Y., Ma, F., Shi, B., & Huang, D. (2018). Forecasting the prices of crude oil: An iterated
Acknowledgments combination approach. Energy Economics, 70, 472–483.
Zhang, Y., Ma, F., & Zhu, B. (2019). Intraday momentum and stock return predictability:
The authors are grateful to the editor and three anonymous referees Evidence from China. Economic Modelling, 76, 319–329.
Zhang, Y., Zeng, Q., Ma, F., & Shi, B. (2019). Forecasting stock returns: Do less powerful pre-
for insightful comments that significantly improved the paper. This dictors help? Economic Modelling. https://doi.org/10.1016/j.econmod.2018.09.014https://
work is supported by Doctoral Innovation Fund Program of Southwest www.sciencedirect.com/science/article/pii/S0264999318301901 (forthcoming).
Zhu, X., & Zhu, J. (2013). Predicting stock returns: A regime-switching combination approach
Jiaotong University [D-CX201724] and Service Science and Innovation and economic links. Journal of Banking & Finance, 37, 4120–4133.
Key Laboratory of Sichuan Province [KL1704]. In particular, Yu Wei