International Review of Financial Analysis 84 (2022) 102339

Contents lists available at ScienceDirect

International Review of Financial Analysis

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

Macroeconomic attention, economic policy uncertainty, and stock

volatility predictability
Feng Ma a, Yangli Guo a, *, Julien Chevallier b, c, Dengshi Huang a
a
School of Economics and Management, Southwest Jiaotong University, Chengdu, China
b
IPAG Business School (IPAG Lab), 184 boulevard Saint-Germain, 75006 Paris, France
c
Université Paris 8 (LED), 2 rue de la Liberté, 93526 Saint-Denis cedex, France

A R T I C L E I N F O A B S T R A C T

Keywords: This study adopts the newly constructed macroeconomic attention indices (MAI) and category-specific economic
Stock return volatility predictability policy uncertainty (EPU) indices to predict stock volatility. Principal component analysis (PCA), scaled PCA
Macroeconomic attention indices (sPCA), and partial least squares (PLS) are used to extract the principal components from indicators. The results
Category-specific EPU indices
show that the combination of MAI and EPU indices can obtain additional information for predicting stock market
sPCA
PCA
volatility. In addition, the comprehensive index containing all indicator information (FAllt ) has the strongest

PLS short-term forecasting ability, whereas the MAI show the most substantial forecasting ability in long-term
forecasting.

1. Introduction
Forecasting financial market volatility has been the focus of aca­
demic and practical research in the past decade. Accurate volatility
forecasting is central to asset pricing, portfolio allocation, security
valuation, monetary policy formulation, and risk management (Engle &
Ng, 1993). In the United States (US), the Federal Reserve considers
volatility in stocks, bonds, currencies, and commodities when setting
monetary policy. In 1996, the Basel Accord mandated volatility fore­
casting as a mandatory risk-management exercise for many financial
institutions worldwide. In addition, volatility forecasting has important
implications for investment choices and is a key factor in corporate and
public debt valuation. Volatility forecasting is also the most important
parameter that affects listed option prices. In general, financial market
volatility affects policymakers' behavior and is the key to financial risk
management.
As a barometer reflecting the economic cycle, modeling and fore­
casting stock market volatility has always attracted the focus of scholars
(Wen, Liu, Dai, He, & Liu, 2022). With the abundance of data, an
increasing number of scholars have used various indicators to predict
stock market volatility, such as the VIX (Bekaert & Hoerova, 2014),
investor sentiment (Lee, Jiang, & Indro, 2002; Wang, Su, & Duxbury,
2022), macroeconomic variables (Paye, 2012), technical indicators
(Neely, Rapach, Tu, & Zhou, 2014), and economic policy uncertainty
(EPU; Arouri, Estay, Rault, & Roubaud, 2016; Li, Ma, Zhang, & Zhang,
2020; Wen, Shui, Cheng, & Gong, 2022). In addition, the stock market is
closely related to macroeconomic fundamentals (Engle, Ghysels, &
Sohn, 2013), and economic development is a key factor in determining
stock market performance. According to Wongbangpo and Sharma
(2002), macroeconomic factors, such as gross national product, con­
sumer price index, money supply, interest rates, and exchange rates, are
interdependent with the stock market. Examining the relationship be­
tween the stock market and macroeconomic variables has important
implications for investors and policymakers. Notably, Fisher, Martineau,
and Sheng (2022) constructed the macroeconomic attention indices
(MAI) based on news information (New York Times and Wall Street
Journal) on eight macroeconomic fundamentals: unemployment, mon­
etary policy, output growth, inflation, housing market, credit ratings,
oil, and the US dollar, which is a new measure of different macroeco­
nomic attention. This study is the first to examine the predictive ability
of MAI for stock market volatility. Considering that the category-specific
EPU indices proposed by Baker, Bloom, and Davis (2016) are also con­
structed based on news data from more than 2000 US newspapers, we
compare the predictive ability of the MAI and the category-specific EPU
indices for stock market volatility and examine whether they contain
different information in predicting stock market volatility.

* Corresponding author.
E-mail addresses: mafeng2016@swjtu.edu.cn (F. Ma), GuoYangli@my.swjtu.edu.cn (Y. Guo), Julien.chevallier@ipag.fr (J. Chevallier), dengshi.huang@126.com
(D. Huang).

https://doi.org/10.1016/j.irfa.2022.102339
Received 28 June 2022; Received in revised form 29 July 2022; Accepted 11 August 2022
Available online 17 August 2022
1057-5219/© 2022 Elsevier Inc. All rights reserved.
F. Ma et al.
The motivations for this study are straightforward. First, we evaluate
the predictive ability of the MAI and EPU indices for stock market
volatility and test whether these two types of indicators contain com­
plementary information for predicting stock market volatility. Second,
we attempt to extract comprehensive indicators using a dimensionality-
reduction method to improve the accuracy of stock market volatility
prediction and observe which dimensionality-reduction method is more
effective. Third, we examine the indicator's predictive ability in different
situations (such as different business cycles and multiple step-ahead
forecasting horizons).
Consistent with other studies on stock volatility forecasting (Chris­
tiansen, Schmeling, & Schrimpf, 2012; Liu, Ma, Zeng, & Zhang, 2020;
Nonejad, 2017), we conduct an empirical analysis based on the autor­
egressive (AR) framework. Specifically, to test the predictive power of
the indices, we first generate individual volatility forecasts by intro­
ducing a single index into the AR model. Accordingly, we can yield 19
individual volatility forecasts for each indicator (8 for the MAI and 11
for the EPU indices). As a single index contains less information, to
comprehensively consider the information contained in the MAI and the
EPU indices, we adopt three commonly used dimensionality-reduction
approaches: principal component analysis (PCA; Pearson, 1901),
scaled PCA (sPCA; Huang, Jiang, Li, Tong, & Zhou, 2022), and partial
least squares (PLS; Wold, 1966), of which sPCA and PLS belong to su­
pervised learning. Subsequently, through these three dimensionality-
reduction methods, we extract comprehensive indicators for MAI,
EPUindices, and all indices (including all MAI and EPU indices), which
are denoted by FMAI t , FEPU
t , and FAll
t , respectively. For comparison, we also
employ the kitchen sink (KS) model, which adds all the required in­
dicators to the AR model simultaneously.
In this study, we use the out-of-sample R2 test as the evaluation
criterion for the prediction results of each model. Several meaningful
empirical results are obtained. First, the out-of-sample R2 test provides
evidence that the AR model with both MAI comprehensive indexes
(FMAI
t ) and the EPU comprehensive indexes (FMAI t ) has stronger fore­
casting ability than the model that only contains one type of compre­
hensive index and the AR model with the comprehensive index that
includes all indicator information (FAll All All
PCA, t, FsPCA, t, FPLS, t) generates the
strongest forecasting power. In addition, the comprehensive indices
extracted by sPCA exhibit stronger predictive power. The results prove
that the MAI and EPU indices contain complementary information for
predicting stock market volatility and combining the two types of in­
dicators can improve forecasting accuracy.
Second, the cumulative squared forecast error (CSFE) and forecast
encompassing tests further confirm the out-of-sample test results. The
CSFE shows that the composite index including all indicators (FAll PCA, t,
FAll All
sPCA, t, FPLS, t) has the strongest predictive ability most of the time. The
forecast encompassing test shows that models with both FMAI t and FEPUt or
All
models with Ft contain additional predictive information compared
with models that include only one type of composite index (FMAI t or
FEPU
t ). Furthermore, the sPCA_MAI_EPU and sPCA_All models contain the
most predictive information. This provides strong evidence that the MAI
and EPU indicators contain complementary information to predict stock
volatility, and that sPCA is the most effective method.
Third, we perform several robustness tests. In particular, we examine
the predictive power of the MAI and EPU indices on stock market
volatility in other G7 countries (France, Italy, the United Kingdom,
Germany, Canada, and Japan), in addition to the US. The results illus­
trate that comprehensive indices extracted by three dimensionality-
reduction methods also have the predictive ability in forecasting the
stock market volatility of G7 countries, and the FAll t index is still the
strongest predictor. Furthermore, we provide evidence that our results
are robust to alternative forecasting window sizes and realized volatility
(RV) lags.
Finally, we analyze the performance of the indicators in different
situations. The first analysis is the performance of the indicators under
different economic cycles. We find that the composite indices extracted
2
International Review of Financial Analysis 84 (2022) 102339
by sPCA have the strongest predictive ability in the recession period,
while those extracted by PCA exhibit the strongest predictive ability in
the expansion period. The second analysis is the performance of the
indicators under high and low volatility regimes. The results demon­
strate that the composite index constructed using PCA has superior
predictive power in low volatility periods. By contrast, the composite
index constructed using sPCA had the strongest predictive power in high
volatility periods. The third analysis is the performance of the indicators
in the multiple step-ahead forecasting horizon. The results show that, in
contrast to short-term (1-month-ahead) forecasts, in which the FAll t index
is the strongest predictor, long-term (3-, 6-, 9-, and 12 -month-ahead)
stock market volatility forecasts mainly rely on the MAI, and the PLS
demonstrates a more efficient ability to extract information. The last
analysis is the variance risk premium (VRP) estimation. We construct a
VRP based on the RV forecast using models containing all indicator in­
formation and forecast future stock market returns. The results further
prove that a model that includes all indicators has a stronger predictive
ability.
Our study is related to that of Fisher et al. (2022), who focused on the
construction of MAI and examined the relationship between the MAI and
the announcement risk premium. However, unlike Fisher et al. (2022),
our study contributes to stock volatility prediction by investigating the
predictive ability of MAI and category-specific EPU indices. First, we
provide strong evidence that the MAI and EPU indices contain com­
plementary information for predicting stock market volatility. Second,
we find that sPCA is more effective in recessions, PCA is more effective in
expansions, and PLS is more effective in long-term forecasting, which
provides a basis for selecting dimensionality-reduction methods in
different economic situations. Third, we find that the FAll t index is more
effective for short-term forecasting, whereas the MAI are more effective
for long-term forecasting.
The remainder of this paper is organized as follows. Section 2 de­
scribes the data used in our empirical analysis. Section 3 describes the
forecasting models and evaluation methods. Section 4 presents the out-
of-sample analysis, including the out-of-sample forecasting perfor­
mance, CSFE, and forecast encompassing tests. Section 5 provides
various robustness tests. Section 6 presents further analysis, including
the different business cycles, high- and low- volatility regimes, multiple-
steps-ahead forecasting horizon, and VRP estimation. Finally, Section 7
presents our conclusions.
2. Data
This study examines the predictability of MAI and category-specific
EPU indices for stock return volatility. The datasets used in this study
include S&P 500 daily data, 8 MAI, and 11 category-specific EPU
indices. To calculate stock market RV, we collected daily S&P 500 data
from investing.com. The MAI can be downloaded from Professor Jinfei
Sheng's homepage,1 and the category-specific EPU indices can be ob­
tained from the EPU website.2 All the datasets cover the sample period
from January 1985 to December 2020.
The MAI are new indicators constructed by Fisher et al. (2022) to
focus on different macroeconomic risks. The authors consider eight
macroeconomic news categories: unemployment, monetary policy,
output growth, inflation, housing market, credit ratings, oil, and the US
dollar. They then measure the attention of each category of macroeco­
nomic news by building a word list to count the number of articles in
each category. The MAI are constructed based on articles from the New
1
https://sites.google.com/site/shengjinfei/data
2
http://www.policyuncertainty.com/categorical_epu.html
F. Ma et al. International Review of Financial Analysis 84 (2022) 102339

York Times and Wall Street Journal. This study uses eight MAI con­ where α0 is a constant term, l is the lag order of RV, and εt+1 denotes the
structed based on the New York Times to predict stock volatility. error term.
Category-specific EPU indices are constructed based on news data To investigate the predictive ability of individual predictors of stock
from more than 2000 US newspapers, with a total of 11 sub-indices.3 volatility, we extend the AR(3) model with individual MAI and EPU
Please refer to Baker et al. (2016) for a more detailed introduction to the indices. The AR-X model can be defined as:
subindexes.
∑2
Table 1 presents the descriptive statistics for stock return RV, 8 MAI, RVt+1 = α0 + ρ RVt− l + βi Xi,tm + εt+1 , (3)
l=0 l
and 11EPU sub-indices. The results in Table 1 show that the skewness
and kurtosis of all series are greater than zero, indicating that all series where m denotes MAI or EPU indices, XMAI i, t represents the i-th index of
are leptokurtic and right-skewed. The Jarque-Bera statistics show that MAI, and XEPU
i, t denotes the i-th index of EPU.
the data reject the null hypothesis of normal distribution at the 1% In addition, following Degiannakis and Filis (2017), Ma, Wahab, and
significance level, further confirming that the data are non-normally Zhang (2019), and Guo et al. (2022), we construct a KS-MAI model by
distributed. The Ljung-Box test rejects the null hypothesis of no auto­ including all MAI indices as explanatory variables in the AR model.
correlation at the 1% significance level for statistics with lags of 5 and Similarly, the KS-EPU model is constructed by combining all the cate­
20. In addition, the augmented Dickey-Fuller test rejects the null hy­ gorical EPU indices with the AR model. Furthermore, to test whether the
pothesis of the existence of a unit root at the 1% significance level, MAI and EPU indices contain complementary information for predicting
indicating that the data are stationary series and can be directly stock return volatility, we construct the KS-All model by combining all
modeled. MAI and EPU indices with the AR model. The KS model can be expressed
as:
3. Methodology
∑2 ∑
n

4
RVt+1 = α0 + ρRVt− l + βi Xi,tm + εt+1 , (4)
3.1. Realized variance l=0 l
i=1

Regression-based approaches to conditional volatility modeling are where m is MAI, EPU, or All (MAI and EPU) indices.
always based on ex-post variance measures. Following Schwert (1989) As an individual variable cannot contain comprehensive predictive
and Paye (2012), we calculate the stock RV as the sum of the squares of information and the KS model may have an overfitting problem that
the daily returns. Specifically, the t-th month RV can be expressed as: influences the predictive effect, we extract the forecast information of
∑n stock return volatility from the MAI and EPU indices using three popular
RVt = r2 ,
d=1 t,d
(1) dimensionality-reduction methods (PCA, sPCA, and PLS).

where n is the number of trading days per month, and rt, d is the d-th 3.2.2. AR model with PCA-aligned index
daily return of month t. Andersen and Bollerslev (1997) found that this PCA is one of the most commonly used dimensionality-reduction
method is an accurate measure of volatility and contains less noise. methods (Chen & Han, 2021; Jiang, Tang, & Zhou, 2018; Zhang,
Fig. 1 depicts the RV of the stock market from January 1985 to Wahab, & Wang, 2022), and its application is based on Pearson (1901).
December 2020. The shaded areas represent the recessionary periods. Mathematically, PCA can extract common information from several
The figure shows that the stock market fluctuated greatly near the indicators by using the following formula:
recession period and was affected by the stock market crash in 1987, the
(5)
′
financial crisis in 2008, and the outbreak of COVID-19; peaks of vola­ xi,t = λi FPCA,t + ei,t ,
tility are evident in October 1987, October 2008, and March 2020.
However, the RV calculated using Eq. (1) is usually non-normal. where xi, t denotes the standardized variables and FPCA, t is the principal
When we perform regression prediction on volatility, we estimate the component extracted by PCA.
regression parameters using ordinary least squares (OLS). However, We separately extract principal components from the MAI, EPU
OLS-based statistical inference is known to be misleading when the index, and all indices, and the comprehensive indices are denoted as
distribution of errors is non-Gaussian. Therefore, following Paye (2012), FMAI EPU All
PCA, t, FPCA, t, FPCA, t, respectively. We then combine these comprehen­

we employ the natural logarithm of RV (RVt = log (RVt)), which is closer sive indices with the AR model to construct PCA_MAI, PCA_EPU, and
to the normal distribution. PCA_All models. The general formula is expressed as follows:
∑2 ∑K
RVt+1 = α0 + ρ RVt− l + β Fm + εt+1 , (6)
3.2. Predictive model l=0 l k=1 k PCA,k,t

where m is the MAI, EPU, or all (MAI and EPU) index and k is the number
3.2.1. AR model and its extensions
of principal components. A large cumulative contribution rate is known
The AR model is one of the most popular predictive models and is
to indicate the strong ability of new variables to synthesize information.
widely used as a benchmark. Following Christiansen et al. (2012), Ma,
To reduce information loss and achieve dimensionality-reduction,
Liu, Wahab, and Zhang (2018), and Wang, Wei, Wu, and Yin (2018), we
following Guo et al. (2022), we select the first k principal components
employ the AR model as the benchmark in this study. Consistent with
whose cumulative contribution rate reaches more than 85%. Specif­
Ma et al. (2018) and Guo, He, Liang, and Ma (2022), we choose a lag
ically, we extract six principal components from the MAI index, five
order of three based on the AIC and SC criteria. The AR model can be
from the EPU index, and nine from all MAI and EPU indices. Figs. A1–A6
defined as
in the appendix show the specific content of the principal components
∑2
RVt+1 = α0 + ρ RVt− l + εt+1 , (2) extracted by PCA and the estimated loading of each variable on the
l=0 l
principal components.
In addition, we also introduce the principal components of MAI
(FMAI EPU
PCA, t) and EPU (FPCA, t) as predictors in the AR model to construct the
3
The 11 category-specific EPU indices include monetary policy, fiscal policy, PCA_MAI_EPU model, which can be expressed as follows:
taxes, government spending, health care, national security, entitlement pro­ ∑2 ∑6 ∑5
grams, regulation, financial regulation, trade policy, sovereign debt, and cur­ RVt+1 = α0 + ρ RVt− l +
l=0 l
β FMA +
k=1 k PCA,k,t
β F EPU + εt+1 . (7)
k=1 k PCA,k,t
rency crises.
4
Realized volatility and realized variance are interchanged in this study.

3
F. Ma et al. International Review of Financial Analysis 84 (2022) 102339

Table 1
Summary statistics of all data.
Variable Mean Std.Dev. Skewness Kurtosis J-B stat. Q (5) Q (20) ADF

RV 0.003 0.007 8.646 88.095 141,788.249*** 85.060*** 90.724*** − 14.433***

credit_rating 0.195 0.164 3.818 31.148 18,089.631*** 430.840*** 813.289*** − 9.940***
gdpi 0.283 0.165 1.472 4.292 476.751*** 447.160*** 1228.638*** − 10.007***
house_mkt 0.240 0.226 1.720 2.849 352.774*** 1521.440*** 5263.665*** − 5.678***
inflation 0.672 0.295 0.846 0.794 61.840*** 630.966*** 1570.549*** − 9.445***
monetary 0.877 0.365 0.756 1.117 62.262*** 555.250*** 1068.324*** − 9.705***
oil 0.633 0.482 2.672 13.240 3586.870*** 861.144*** 1564.165*** − 7.487***
unemp 0.685 0.374 1.422 2.304 236.801*** 1074.339*** 2431.574*** − 6.822***
usd 0.063 0.092 2.170 3.914 604.280*** 1478.637*** 3900.434*** − 5.694***
Monetary policy 93.527 59.250 1.701 4.136 505.728*** 233.133*** 313.357*** − 10.537***
Fiscal policy 108.152 68.174 1.627 2.978 343.848*** 599.852*** 888.807*** − 7.376***
Taxes 109.067 69.151 1.796 4.108 525.547*** 632.724*** 889.138*** − 7.222***
Government spending 103.344 95.538 2.361 7.122 1287.049*** 429.995*** 774.104*** − 8.717***
Health care 128.171 115.269 2.994 14.188 4174.018*** 734.094*** 1218.380*** − 6.614***
National security 95.966 77.912 3.800 21.275 8982.005*** 498.190*** 760.686*** − 8.853***
Entitlement programs 121.820 121.756 3.718 19.341 7557.484*** 602.119*** 704.036*** − 7.296***
Regulation 108.291 55.759 1.627 3.652 421.878*** 553.375*** 1014.527*** − 9.087***
Financial regulation 103.230 113.373 2.763 10.262 2392.907*** 435.548*** 744.254*** − 10.823***
Trade policy 128.545 183.821 4.587 30.453 17,799.640*** 858.946*** 1665.607*** − 8.364***
Sovereign debt, currency crises 106.887 186.150 4.223 23.001 10,568.194*** 440.280*** 610.620*** − 9.530***

Notes: This table presents descriptive statistics for stock return realized volatility, 8 MAI indices, and 11 EPU sub-indices. St. dev. Denotes standard error. J-B stat. is the
Jarque–Bera statistic, and the Jarque–Bera test is a method of testing the normality of population distribution. Q(n) is the Ljung–Box statistic with lag order n and the
null hypothesis of no autocorrelation. ADF is the statistic of the Augmented Dickey–Fuller test, the null hypothesis of which is the existence of a unit root. The asterisk
*** indicates rejection of the null hypothesis at the 1% significance level.

0.09

0.08

0.07

0.06

0.05

0.04

0.03

0.02

0.01

0
199001 200001 201001 202001

Fig. 1. Stock return realized volatility during the whole sample.

3.2.3. AR model with sPCA-aligned index We can then extract principal components for the scaled variables
The sPCA is a new dimension reduction method based on PCA and (β1X1, t, β2X2, t, …, βiXi, t):
was improved by Huang et al. (2022). The sPCA assigns different
(9)
′

weights to each indicator by considering the target information, which βi Xi,t = λi FsPCA,t + ei,t ,
belongs to supervised learning. Specifically, the principal components
where FsPCA, t denotes the comprehensive index extracted by sPCA.
are extracted in two steps. First, we perform univariate regression to
We then use sPCA to extract principal components for MAI, EPU, and
determine the predictive power of each predictor, whose formula can be
all indices, FMAI EPU All
sPCA, t, FsPCA, t, and FsPCA, t, respectively. These are intro­
expressed as:
duced in the AR model to construct sPCA_MAI, sPCA_EPU, and sPCA_All
RVt+1 = αn + βi Xi,t + εt+1 , (8) models.

where βi represents the weight of different predictors.

4
F. Ma et al. International Review of Financial Analysis 84 (2022) 102339

∑2 ∑K 3.3. Evaluation method

RVt+1 = α0 + ρ
l=0 l
RVt− l + β Fm
k=1 k sPCA,k,t
+ εt+1 , (10)

Similar to PCA, we also select k principal components, whose cu­ To assess the predictive ability of the forecasting models, following
mulative contribution rate reached 85%. Specifically, we extract four Campbell and Thompson (2008) and Rapach, Strauss, and Zhou (2010),
principal components from the MAI index, four from the EPU index, and we use out-of-sample R2 as the prediction evaluation criterion. The R2oos
six from all the MAI and EPU indices. The specific content of the prin­ statistic reflects the percentage reduction in the mean squared predic­
cipal components extracted by sPCA and the estimated loading of each tion error (MSPE) in the forecast model compared with the baseline
variable on the principal components are illustrated in Figs. A7–A12 in model. The R2oos statistic can be expressed as:
the appendix. ∑T ( )2
Furthermore, we also combine the FMAI EPU RVt − ̂
sPCA, tand FsPCA, t with AR model,
RV t,F
R2oos = 1 − ∑t=M+1 ( ) , (16)
the sPCA_MAI_EPU model, which can be expressed as follows:
T 2
t=M+1 RVt − ̂
RV t,B
∑2 ∑4 ∑4
RVt+1 = α0 + ρ RVt− l +
l=0 l
β FMA
k=1 k sPCA,k,t
+ β FEPU + εt+1 .
k=1 k sPCA,k,t
where T represents the number of full samples, M is the number of in-
(11) samples, RVt is the true value of RV, ̂ RV t,F represents the forecast
value of the predictive model, and ̂ RV t,B represents the forecast value of
3.2.4. AR model with PLS-aligned index the benchmark model. The AR model is used as the benchmark model for
The PLS is a dimensionality-reduction method originally suggested comparison with other predictive models. A positive R2oos indicates that
by Wold (1966). Similar to the sPCA, PLS is a supervised learning the prediction model has a smaller mean square error, that is, the pre­
method, which can extract principal components from several predictors dictive ability of the prediction model is stronger than that of the
and remove irrelevant components (Huang, Jiang, Tong, & Zhou, 2015). benchmark model.
The process of extracting the factors using the PLS can be divided into Additionally, we use Clark and West's (2007) MSPE-adjusted model
two steps. First, we employ Eq. (12) to extract the drivers of predictors to further test whether the MSPE of the forecast model produces a sta­
from the future RV: tistically significant improvement over the benchmark model, which can
Xi,t− = αi,0 + βi RVt + ei,t− 1 . (12) be defined as:
1
( )2 ( )2 ( )2
Second, the PLS common index can be obtained by the regression of ft = RVt − ̂ RV t,B − RVt − ̂RV t,F + RVt,B − ̂ RV t,F . (17)
the i-th variable Xi, t on the corresponding coefficient ̂
βi:
4. Out-of-sample analysis
Xi,t = φi,0 + FPLS,t ̂
β i + μi,t− 1 , (13)
As we all know, investors are more interested in the ability of models
where FPLS, t is the common index extracted by the PLS.
to predict future volatility; therefore, we focus on out-of-sample esti­
Similar to PCA and sPCA, we use FMAI EPU All
PLS, t, FPLS, t, and FPLS, t to build mates. The entire sample interval covers January 1985 to December
PLS_MAI, PLS_EPU, and PLS_All models, which can be defined as:
2020 and contains 432 months of data. We divide the full sample into in-
∑2 sample and out-of-sample intervals. The in-sample contains 100 months
RVt+1 = α0 + m
ρ RVt− l + β1 FPLS,t + εt+1 , (14)
l=0 l of data from January 1985 to April 1993 and the out-of-sample contains
data from May 1993 to December 2020. Out-of-sample forecasts are
where m is the MAI, EPU, or All (MAI and EPU) index.
obtained using an expanding (recursive) approach.
In addition, we also combine the FMAI EPU
PLS, tand FPLS, t with AR model, the
PLS_MAI_EPU, which model can be defined as follows:
∑2 4.1. Out-of-sample forecast performance
RVt+1 = α0 + MAI
ρ RVt− l + β1 FPLS,t
l=0 l
EPU
+ β2 FPLS,t + εt+1 . (15)

The specific content of the principal components extracted by the To examine which predictor is more powerful in forecasting stock
PLS and the estimated loading of each variable on the principal com­ volatility, we first evaluate the predictive performance of individual
ponents are shown in Figs. A13–A18 in the appendix. predictors. Table 3 shows the prediction results of the out-of-sample R2
Table 2 reports all the prediction models employed in this study. for the individual variable models (AR-X) of the 8 MAI indices and 11
EPU indices. The results in Table 3 demonstrate that the forecast per­
formance of AR-X models is weaker. Specifically, only the output growth
Table 2 (gdpi) in the MAI index and trade policy in the EPU index generate
Description of forecasting models. positive and significant R2oos statistic. One possible reason for this is that
Category Model name Equation output growth is closely associated with the stock market. Ahn and Lee
(2006) show that high volatility in real output leads to increased stock
Benchmark model AR Eq. (2)
Individual variable model AR-X Eq. (3)
market volatility. In addition, trade policy uncertainty is a systemic risk
Kitchen sink model KS_MAI Eq. (4) factor affecting asset prices, and US companies are more vulnerable to
KS_EPU Eq. (4) tariff uncertainty (Bianconi, Esposito, & Sammon, 2021). Bhowmik
KS_All Eq. (4) (2013) found that trade policy is an important factor in explaining stock
Principal component analysis model PCA_MAI Eq. (6)
market volatility.
PCA_EPU Eq. (6)
PCA_ALL Eq. (6) It is difficult for an individual variable to predict stock return vola­
PCA_MAI_EPU Eq. (7) tility. To determine how to extract effective information for predicting
Scaled principal component analysis model sPCA_MAI Eq. (10) stock market volatility from numerous indicators, we further test the
sPCA_EPU Eq. (10) predictive ability of the KS, PCA, sPCA, and PLS models. The results are
sPCA_All Eq. (10)
sPCA_MAI_EPU Eq. (11)
presented in Table 4. In contrast to individual predictors, the model with
Partial least squares model PLS_MAI Eq. (14) a comprehensive index demonstrates the superior predictive ability.
PLS_EPU Eq. (14) First, except for the KS-MAI model, the R2oos statistics of all models are
PLS_All Eq. (14) positive and significant. Second, the model containing both the MAI and
PLS_MAI_EPU Eq. (15)
EPU comprehensive indices (FMAI t , FEPU
t , respectively) have stronger
Notes: This table shows all the predictive models employed in this paper. forecasting ability than the model that only contains one type of

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F. Ma et al. International Review of Financial Analysis 84 (2022) 102339

Table 3 methods can extract principal components from a large amount of

Out-of-sample R2 results of individual predictors. data, their action mechanisms differ. The PCA assigns the same weight
Category Forecasting models R2OOS(%) MSPE- p- to all variables in the process of extracting principal components; that is,
Adj. value even if a variable has no connection with the target variable, PCA cannot
Benchmark model AR – – – filter it, which may lead to too much noise and ignore important in­
Macroeconomic attention credit_rating − 4.378 − 1.322 0.907 formation. However, sPCA considers the forecast target information and
indices gdpi 7.707 2.155 0.016 assigns different weights according to the predictive ability of the var­
house_mkt 4.186 0.913 0.181 iable. Specifically, variables with stronger predictive power are
inflation − 0.656 − 1.070 0.858
monetary − 5.914 − 0.886 0.812
weighted more heavily. Therefore, the sPCA can extract more effective
oil − 0.155 − 1.146 0.874 information from numerous indicators.
unemp − 1.779 − 0.134 0.553
usd − 1.186 − 0.323 0.627
4.2. Cumulative squared forecast error
Category-specific policy Monetary policy − 3.347 − 0.975 0.835
uncertainty indices Fiscal Policy − 0.568 0.136 0.446
Taxes − 0.856 0.081 0.468 To better observe the changes in the predictive model performance
Government − 0.514 − 0.301 0.618 over the out-of-sample period, consistent with Welch and Goyal (2008)
spending and Wang, Ma, Wahab, and Ma (2021), we calculate the difference be­
Health care − 0.932 0.180 0.429
National security − 0.249 0.020 0.492
tween the CSFE of the benchmark and forecast models, which can be
Entitlement 0.241 0.588 0.278 expressed as:
programs
Regulation − 5.149 − 1.156 0.876
∑
T
( i )2 ( bench )2
CSFEi = (̂
RV − RVt − ̂
RV t − RVt , (18)
Financial 0.585 0.487 0.313 t
t=M+1
Regulation
Trade policy 1.293 1.425 0.077
Sovereign debt, − 0.375 − 0.448 0.673 where T represents the number of full samples, M is the number of in-
i
currency crises samples, ̂
RV t denotes the forecasts of the ith forecast model, and
Notes: This table reports the out-of-sample R2 results for the individual pre­ ̂
RV t
bench
is the forecast of the benchmark model. A negative CSFE in­
dictors (AR-X models). A positive R2oos value indicates that the predictive model
dicates that the prediction model is superior to the benchmark model.
is superior to the benchmark model. The significance of the R2oos statistic is based
Figs. 2–5 depict the CSFE of the models with a comprehensive index.
on Clark and West's (2007) MSFE-adjusted statistic. Out-of-sample forecasts
span 332 months from May 1993 to December 2020. We find several interesting results. First, the results in Figs. 2–5 are
consistent with the out-of-sample results, and the composite index
including all indicators (FAll All All
PCA, t, FsPCA, t, FPLS, t) has the strongest pre­
Table 4 dictive ability most of the time. Second, the predictive ability of all
Out-of-sample R2 results of comprehensive information. models around October 2008 is greatly improved, indicating that the
Category Forecasting R2OOS(%) MSPE- p- composite index showed stronger predictive ability during the financial
models Adj. value crisis period. Third, in general, the predictive ability of the sPCA models
Benchmark model AR – – –
is better than that of other models over time.
Kitchen sink model KS-MAI − 0.584 1.841 0.033
KS-EPU 3.865 1.356 0.088 4.3. Forecast encompassing tests
KS-ALL 12.536 2.214 0.013
Principal component PCA_MAI 3.678 2.107 0.018
analysis model PCA_EPU 6.185 1.449 0.074 We use the forecast encompassing test to further examine whether
PCA_MAI_EPU 13.615 2.256 0.012 considering both the MAI and EPU indices can obtain additional fore­
PCA_ALL 15.933 2.105 0.018 casting information, following Lin (2018) and Jiang, Lee, Martin, and
Scaled principal component sPCA_MAI 10.130 2.165 0.015
Zhou (2019). Mathematically, the forecast encompassing tests can be
analysis model sPCA_EPU 9.679 1.417 0.078
sPCA_MAI_EPU 23.628 1.803 0.036
expressed as:
sPCA_ALL 26.733 1.852 0.032
Partial least squares model PLS_MAI 3.219 1.701 0.044 RVt+1 = (1 − λ)̂
RV q,t+1 + λ̂
RV p,t+1 , (19)
PLS_EPU 5.230 1.837 0.033
PLS_MAI_EPU 8.780 2.295 0.011 where ̂
RV p,t+1 is the predicted value obtained by the model of interest
PLS_ALL 9.143 2.269 0.012
and ̂ RV q,t+1 is the predicted value of model q, which is used for com­
Notes: This table reports the out-of-sample R2 results for the comprehensive parison. If λ(1 − λ) = 0, it indicates that the two models have an in­
information. A positive R2oos value indicates that the predictive model is superior
clusion relationship. Specifically, λ=0 indicates that the prediction
to the benchmark model. The significance of the R2oos statistic is based on Clark
information in model q exceeds that contained in model p. Conversely,
and West's (2007) MSFE-adjusted statistic. Out-of-sample forecasts span 332
months from May 1993 to December 2020.
(1 − λ) = 0 means that model p comprises model q. We utilize a statistic
proposed by Harvey, Leybourne, and Newbold (1998) to examine the
null hypotheses that the model of interest does not contain any addi­
comprehensive index. Third, the predictive ability of the comprehensive
tional information beyond that contained in the comparison models (i.
index that includes all indicator information (FAll All All
PCA, t, FsPCA, t, FPLS, t) is
e., H0:λ(1 − λ)=0) against the alternative hypothesis that the model of
significantly stronger than that of other comprehensive indices.
interest contains information in addition to the information contained in
Overall, the results show that the comprehensive indicators extrac­
the comparison model.
ted by the three dimensionality-reduction methods can predict stock
Table 5 reports the p values of forecast encompassing tests. First,
return volatility. The MAI and EPU indices contain complementary in­
models with both FMAI t and FEPU
t or models with FAll
t contain additional
formation for predicting stock volatility, and the combination of these
predictive information compared with models that include only one type
two types of indicators can significantly improve the model's predictive
of composite index (FMAIt or FEPU
t ). This indicates that the MAI and EPU
power. In addition, the comprehensive index extracted using the sPCA
indices contain complementary information for predicting stock vola­
dimensionality-reduction method has the strongest predictive ability. A
tility. Combining the two types of indicators can improve the predictive
possible reason is that, although these three dimensionality-reduction
ability, which is consistent with the out-of-sample test results in Table 4.

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F. Ma et al. International Review of Financial Analysis 84 (2022) 102339

10-4
2

-2

-4

-6 KS-All
KS-EPU
KS-MAI
-8
199501 200001 200501 201001 201501 202001

Fig. 2. Difference in CSFE of kitchen sink models.

10-4
2

-2

-4

PCA-All
-6 PCA-MAI-EPU
PCA-EPU
PCA-MAI

-8
199501 200001 200501 201001 201501 202001

Fig. 3. Difference in CSFE of principal component analysis models.

10-4
2

-2

-4

-6

-8
sPCA-All
-10 sPCA-MAI-EPU
sPCA-EPU
-12 sPCA-MAI

-14
199501 200001 200501 201001 201501 202001

Fig. 4. Difference in CSFE of scaled principal component analysis models.

Second, most of the comprehensive indicators extracted by the
dimensionality-reduction method contain more predictive information
than the KS model, indicating that more indicators do not necessarily
contain more predictive information. Third, in general, the models with
the maximum amount of prediction information are sPCA_MAI_EPU and
sPCA_All, which confirms the superiority of the sPCA method.
Overall, the forecast encompassing tests in Table 5 provide strong
evidence that the combined MAI and EPU indices can provide additional
information for predicting stock market return volatility, confirming the
superiority of the out-of-sample predictive performance reported in
Table 4.

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F. Ma et al. International Review of Financial Analysis 84 (2022) 102339

10-4
1

-1

-2

-3 PLS-All
PLS-MAI-EPU
-4 PLS-EPU
PLS-MAI

-5
199501 200001 200501 201001 201501 202001

Fig. 5. Difference in CSFE of partial least squares models.

Table 5
Forecast encompassing test results.
Forecasting models PCA_MAI_EPU PCA_ALL sPCA_MAI_EPU sPCA_ALL PLS_MAI_EPU PLS_ALL

λ 1− λ λ 1− λ λ 1− λ λ 1− λ λ 1− λ λ 1− λ

AR 0.016 0.586 0.025 0.569 0.038 0.397 0.035 0.701 0.019 0.628 0.021 0.744

Panel A: Kitchen sink model

KS-MAI 0.035 0.865 0.043 0.805 0.051 0.516 0.041 0.737 0.045 0.717 0.039 0.682
KS-EPU 0.045 0.063 0.031 0.258 0.030 0.505 0.027 0.818 0.060 0.036 0.059 0.042
KS-ALL 0.087 0.192 0.038 0.411 0.113 0.683 0.049 0.827 0.108 0.050 0.103 0.049

Panel B: Principal component analysis model

PCA_MAI 0.044 0.854 0.055 0.741 0.056 0.464 0.046 0.717 0.047 0.673 0.041 0.637
PCA_EPU 0.027 0.199 0.015 0.438 0.029 0.445 0.030 0.783 0.101 0.049 0.097 0.054
PCA_MAI_EPU – – 0.177 0.550 0.111 0.532 0.090 0.793 0.678 0.051 0.605 0.049
PCA_ALL 0.550 0.177 – – 0.108 0.539 0.070 0.803 0.484 0.044 0.465 0.045

Panel C: Scaled principal component analysis model

sPCA_MAI 0.016 0.655 0.033 0.597 0.052 0.466 0.040 0.742 0.394 0.076 0.314 0.065
sPCA_EPU 0.099 0.020 0.063 0.107 0.038 0.417 0.036 0.775 0.150 0.028 0.153 0.032
sPCA_MAI_EPU 0.532 0.111 0.539 0.108 – – 0.186 0.488 0.423 0.061 0.414 0.060
sPCA_ALL 0.793 0.090 0.803 0.070 0.488 0.186 – – 0.750 0.058 0.746 0.058

Panel D: Partial least squares model

PLS_MAI 0.049 0.714 0.048 0.556 0.059 0.413 0.054 0.708 0.075 0.824 0.065 0.808
PLS_EPU 0.011 0.478 0.018 0.520 0.038 0.408 0.037 0.741 0.041 0.296 0.041 0.532
PLS_MAI_EPU 0.051 0.678 0.044 0.484 0.061 0.423 0.058 0.750 – – 0.176 0.616
PLS_ALL 0.049 0.605 0.045 0.465 0.060 0.414 0.058 0.746 0.616 0.176 – –

Note: The table represents p-values for Harvey et al.'s (1998) statistic. The p-values in the “λ” column examine the null hypothesis that the competing forecasts in the
first column encompass the forecasts in the first row, against the alternative hypothesis that the competing forecasts in the first column do not encompass the forecasts
in the first row. Similarly, the p-values in the “1 − λ” column examine the null hypothesis that the forecasts in the first row encompass competing forecasts in the first
column, against the alternative hypothesis that the forecasts in the first row do not encompass the competing forecasts in the first column.

5. Robustness tests
5.1. Alternative size of forecasting window
Rossi and Inoue (2012) show that out-of-sample forecast results are
affected by different forecast periods. Therefore, examining out-of-
sample prediction results for different periods by changing the win­
dow size is necessary. This section re-examines the prediction results for
the in-sample prediction window sizes of 50 and 150. The corresponding
out-of-sample prediction intervals are March 1989 to December 2020
and July 1997 to December 2020, respectively.
Table 6 reports the forecast results for in-sample prediction window
sizes of 50 (Panel A) and 150 (Panel B). First, we find that R2oos statistics
are positive for all models except for the KS-MAI model, indicating that
most indices have predictive power, and FAll t still has the strongest pre­
dictive power. Second, introducing both FMAI t and FEPU
t into the same
model can significantly improve predictive power. Third, sPCA is still
the most effective dimensionality-reduction method. In summary, the
prediction results of different window sizes are completely consistent
with the prediction results of the out-of-sample test (Table 4), indicating
that the out-of-sample results are robust.
5.2. Alternative lags of RV
The lags of RV can also impact the results (Lu, Ma, Wang, & Wang,
2020). This subsection examines the out-of-sample results for RV at lag
6, which are presented in Table 7.
First, including both the MAI and EPU indicators can improve the

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F. Ma et al. International Review of Financial Analysis 84 (2022) 102339

Table 6 ability of the MAI and EPU indices on the stock markets of the respective
Out-of-sample results for different window sizes. countries. The stock markets of these countries are denoted by the
Forecasting Panel A: The length of in- Panel B: The length of in- following stock indices: CAC40 index for France, FTSE MIB index for
models sample is 50 sample is 150 Italy, FTSE 100 index for England, DAX index for Germany, S&P/TSX
R2oos(%) MSPE- p- R2oos(%) MSPE- p- Composite index for Canada, and Nikkei 225 index for Japan.
Adj. value Adj. value Table 8 presents the results of the out-of-sample R2 tests for stock
AR – – – – – –
return volatility in the six countries. First, the R2oos statistics of most
countries are positive, indicating that the composite index also has
predictive power for countries other than the US. Second, similar to the
Kitchen sink model
KS-MAI − 0.889 1.847 0.032 − 0.501 1.847 0.032 US stock market, the FAllt index is still the strongest predictor. Third,
KS-EPU 3.448 1.352 0.088 3.804 1.347 0.089 adding the FMAI
t and FEPU
t indices to the same model improves the pre­
KS-ALL 11.777 2.217 0.013 12.544 2.209 0.014 dictive ability of the stock markets of various countries. Fourth, the
performance of the three dimensionality-reduction methods varies in
Principal component analysis model different countries. Specifically, among the stock market volatility
PCA_MAI 3.527 2.117 0.017 3.712 2.109 0.017 forecasts in France, Italy, and the United Kingdom, the comprehensive
PCA_EPU 5.671 1.423 0.077 6.165 1.439 0.075
index extracted by the sPCA has the strongest predictive ability, and the
PCA_MAI_EPU 13.027 2.247 0.012 13.651 2.253 0.012
PCA_ALL 15.377 2.102 0.018 16.008 2.106 0.018
PCA is more effective than the other methods in stock market forecasts
in Germany, Canada, and Japan.
Scaled principal component analysis model
sPCA_MAI 9.979 2.181 0.015 10.158 2.165 0.015 6. Further analysis
sPCA_EPU 9.235 1.409 0.079 9.659 1.412 0.079
sPCA_MAI_EPU 22.983 1.803 0.036 23.673 1.801 0.036 6.1. Out-of-sample performance over business cycles
sPCA_ALL 26.103 1.854 0.032 26.782 1.850 0.032

To test the predictive ability of the composite index extracted by

Partial least squares model three dimensionality-reduction methods over expansions and re­
PLS_MAI 3.328 1.762 0.039 3.220 1.698 0.045
cessions, following Liu et al. (2020) and Zhang, Ma, Liang, and Zhang
PLS_EPU 5.086 1.854 0.032 5.187 1.812 0.035
PLS_MAI_EPU 8.688 2.339 0.010 8.762 2.284 0.011 (2021), we adopt the out-of-sample R2 test. The out-of-sample R2 of the
PLS_ALL 9.133 2.305 0.011 9.126 2.258 0.012 recession and expansion periods can be defined as:
Notes: This table reports the out-of-sample R2 test results for different window ∑T (
Itc RVt − ̂
RV t,F
)2
sizes. The out-of-sample forecast with a window size of 50 is from March 1989 to R2oos,c = 1 − ∑t=M+1
T ( )2 , (20)
December 2020, and the out-of-sample forecast with a window size of 150 t=M+1 tI c RVt − ̂
RV t,B
covers July 1997 to December 2020.
where c denotes recession or expansion, while Irec
t and It
exp
take values of
1 when the t-th month is a recession and an expansion period, respec­
Table 7 tively, and 0 otherwise.
Out-of-sample results for different lags of RV. Table 9 reports the predictive power of the comprehensive indices
Category Forecasting R2OOS(%) MSPE- p- over business cycles. Panels A and B depict the results of recessions and
models Adj. value expansions, respectively. First, we find that the R2oos statistics of most
Benchmark model AR – – – models are positive, whether in recession or expansion, indicating that
Kitchen sink model KS-MAI 0.991 2.228 0.013 the composite index extracted by three dimensionality-reduction
KS-EPU 1.649 1.185 0.118 methods can predict stock market volatility. In particular, the compos­
KS-ALL 12.583 1.897 0.029 ite index extracted from all indicators (FAll
t ) has the strongest predictive
Principal component PCA_MAI 3.323 2.527 0.006
analysis model PCA_EPU 3.962 1.142 0.127
power. At the same time, including the MAI composite index (FMAI t ) and
PCA_MAI_EPU 10.481 1.897 0.029 EPU composite index (FEPU
t ) in the same model can significantly improve
PCA_ALL 13.175 1.769 0.038 the prediction ability. Second, the predictive power of all indices de­
Scaled principal component sPCA_MAI 9.325 1.818 0.035 creases during expansions compared with recessions. This may be due to
analysis model sPCA_EPU 8.008 1.296 0.097
increased economic uncertainty and increased focus on macroeconomic
sPCA_MAI_EPU 21.416 1.615 0.053
sPCA_ALL 21.384 1.645 0.050 news during recessions, leading to better forecasting during recessions.
Partial least squares model PLS_MAI 1.769 1.948 0.026 Third, on the whole, the composite indices extracted by the sPCA have
PLS_EPU 3.527 1.534 0.063 the strongest predictive ability in the recession period, while the com­
PLS_MAI_EPU 6.078 2.150 0.016 posite indices extracted by the PCA show the strongest predictive ability
PLS_ALL 6.176 2.137 0.016
in the expansion period. One possible reason is that the sPCA determines
Notes: This table reports out-of-sample results for different RV lags. A positive the forecasting ability of predictors by regressing the target variable
R2oos value indicates that the predictive model is superior to the benchmark with an individual prediction index and assigning different weights to
model. the predictors according to the regression coefficient. As we all know,
the volatility during a recession period is higher than that during the
predictive power of the model, and models with FAll t perform the best. expansion period. In this paper, the average values of volatility during
Second, among the three dimensionality-reduction methods, the infor­ expansion and recession periods are 0.0022and 0.0103, respectively.
mation extracted by the sPCA is the most effective for forecasting stock Therefore, compared with the expansion period, the sPCA assigns a
price volatility. This finding is consistent with the out-of-sample test higher weight to the indicators with strong predictive ability in the
results. recession period, which explains why the comprehensive index extrac­
ted by the sPCA has stronger predictive ability in the recession period.
5.3. Stock volatility forecasts in different countries
6.2. Out-of-sample performance under high and low volatility regimes
This section uses G7 countries other than the US (France, Italy, En­
gland, Germany, Canada, and Japan) as examples to test the predictive In this section, we further test the predictive ability of the composite

9
 F. Ma et al.
Table 8
Out-of-sample R2 tests for stock volatility forecasts in different countries.
Forecasting Panel A: France Panel B: Italy Panel C: The United Kingdom Panel D: Germany Panel E: Canada Panel F: Japan
models 2 2 2 2 2 2
Roos (%) MSPE- p- Roos (%) MSPE- p- Roos MSPE- p- Roos (%) MSPE- p- Roos (%) MSPE- p- Roos (%) MSPE- p-
Adj. value Adj. value (%) Adj. value Adj. value Adj. value Adj. value

AR – – – – – –

Kitchen sink model

KS-MAI 0.614 1.353 0.088 18.732 2.598 0.005 1.840 1.450 0.074 0.995 1.112 0.133 6.153 2.016 0.022 1.827 1.078 0.141
KS-EPU 15.009 1.394 0.082 − 2.737 0.825 0.205 19.680 1.051 0.147 7.721 1.336 0.091 − 3.844 0.838 0.201 1.518 1.481 0.069
KS-ALL 8.422 2.020 0.022 7.901 0.991 0.161 8.078 2.332 0.010 8.952 1.678 0.047 18.637 1.906 0.028 − 0.005 1.805 0.036

Principal component analysis model

PCA_MAI 1.637 1.872 0.031 30.800 1.258 0.104 3.692 1.567 0.059 2.465 1.648 0.050 4.121 1.891 0.029 2.605 1.053 0.146
PCA_EPU 8.961 1.014 0.155 16.965 1.010 0.156 11.619 0.870 0.192 3.596 0.876 0.190 6.697 1.334 0.091 − 1.295 0.829 0.204
10

PCA_MAI_EPU 20.581 1.560 0.059 25.795 1.066 0.143 26.777 1.425 0.077 19.143 1.695 0.045 16.251 2.118 0.017 2.914 1.422 0.077
PCA_ALL 22.233 1.416 0.078 31.570 1.166 0.122 29.113 1.317 0.094 19.722 1.457 0.073 18.958 1.843 0.033 3.698 1.325 0.093

Scaled principal component analysis model

sPCA_MAI 3.245 2.109 0.017 28.217 1.577 0.057 16.586 1.504 0.066 0.516 0.596 0.276 7.801 2.104 0.018 1.381 1.067 0.143
sPCA_EPU 10.095 0.911 0.181 19.977 1.352 0.088 8.533 0.762 0.223 2.310 0.762 0.223 4.659 1.188 0.118 − 2.769 − 0.716 0.763
sPCA_MAI_EPU 24.416 1.402 0.080 31.203 1.436 0.076 31.981 1.263 0.103 11.856 1.417 0.078 17.626 2.218 0.013 1.722 1.150 0.125
sPCA_ALL 22.745 1.181 0.119 37.748 1.472 0.070 30.733 1.195 0.116 15.542 1.166 0.122 9.736 2.230 0.013 1.060 1.303 0.096

Partial least squares model

International Review of Financial Analysis 84 (2022) 102339

PLS_MAI − 0.644 0.580 0.281 22.810 1.363 0.086 10.092 1.340 0.090 − 0.525 0.302 0.381 − 1.584 1.178 0.119 − 0.486 0.648 0.259
PLS_EPU 1.575 1.380 0.084 25.699 1.252 0.105 1.784 0.819 0.206 − 0.859 0.857 0.196 0.477 0.589 0.278 − 1.758 − 0.032 0.513
PLS_MAI_EPU 2.414 1.749 0.040 33.288 1.376 0.084 21.381 1.210 0.113 − 0.612 1.149 0.125 0.847 1.297 0.097 − 1.167 0.801 0.212
PLS_ALL 0.780 1.152 0.125 36.813 1.357 0.087 5.341 1.643 0.050 0.507 0.884 0.188 1.783 1.452 0.073 − 0.843 1.063 0.144

Notes: This table reports the out-of-sample performance of the model with comprehensive indices in G7 countries (except the US). A positive R2oos value indicates that the predictive model is superior to the benchmark
model.
F. Ma et al. International Review of Financial Analysis 84 (2022) 102339

Table 9 Table 10
Out-of-sample performance during the recession and expansion periods. Out-of-sample performance under the high and low volatility regimes.
Forecasting Panel A: Recession period Panel B: Expansion period Forecasting Panel A: High Volatility Level Panel B: Low Volatility Level
models models
R2oos(%) MSPE- p- R2oos(%) MSPE- p- R2oos(%) MSPE- p- R2oos(%) MSPE- p-
Adj. value Adj. value Adj. value Adj. value

AR – – – – – – AR – – – – – –

Kitchen sink model Kitchen sink model

KS-MAI − 0.419 1.267 0.103 6.263 1.503 0.066 KS-MAI − 1.270 1.469 0.071 8.026 2.297 0.011
KS-EPU 1.484 1.121 0.131 − 1.121 1.482 0.069 KS-EPU 1.113 1.173 0.120 3.719 1.874 0.030
KS-ALL 7.318 2.078 0.019 − 3.487 1.707 0.044 KS-ALL 4.739 1.985 0.024 16.334 3.587 0.000

Principal component analysis model Principal component analysis model

PCA_MAI 1.182 1.585 0.057 7.781 1.592 0.056 PCA_MAI 0.954 1.755 0.040 12.502 2.670 0.004
PCA_EPU 2.659 1.113 0.133 3.745 1.405 0.080 PCA_EPU 2.559 1.234 0.109 2.008 1.746 0.040
PCA_MAI_EPU 6.685 2.042 0.021 4.919 1.756 0.040 PCA_MAI_EPU 5.662 2.017 0.022 17.261 3.541 0.000
PCA_ALL 7.797 1.776 0.038 8.212 1.535 0.062 PCA_ALL 6.539 1.872 0.031 15.052 3.659 0.000

Scaled principal component analysis model Scaled principal component analysis model
sPCA_MAI 5.469 2.052 0.020 4.928 1.365 0.086 sPCA_MAI 4.707 2.104 0.018 − 2.081 0.597 0.275
sPCA_EPU 4.327 1.199 0.115 5.901 1.620 0.053 sPCA_EPU 4.185 1.300 0.097 6.595 2.215 0.013
sPCA_MAI_EPU 12.162 1.722 0.043 6.592 1.602 0.055 sPCA_MAI_EPU 10.969 1.751 0.040 6.878 2.277 0.011
sPCA_ALL 13.568 1.758 0.039 6.041 1.737 0.041 sPCA_ALL 12.511 1.792 0.037 5.150 2.127 0.017

Partial least squares model Partial least squares model

PLS_MAI 1.601 1.570 0.058 0.102 0.846 0.199 PLS_MAI 1.903 1.798 0.036 − 13.057 − 1.452 0.927
PLS_EPU 2.294 1.358 0.087 − 0.332 0.973 0.165 PLS_EPU 1.901 1.298 0.097 6.193 2.212 0.013
PLS_MAI_EPU 3.940 1.974 0.024 0.654 1.185 0.118 PLS_MAI_EPU 3.863 2.069 0.019 − 4.633 0.787 0.216
PLS_ALL 4.322 2.000 0.023 − 0.912 1.001 0.158 PLS_ALL 3.890 1.988 0.023 0.327 1.518 0.064

Notes: This table shows the out-of-sample performance of the model with
comprehensive indices during expansions and recessions. A positive R2oos value
indicates that the predictive model is superior to the benchmark model.
index under high/low volatility. Following Liang, Tang, Li, and Wei
(2020) and Tang, Xiao, Wahab, and Ma (2021), we divide volatility into
high and low volatility based on the average of stock volatility in the out-
of-sample interval. Specifically, stock volatility greater than the mean
volatility (i.e., RVt > RVt ) is defined as high volatility and stock vola­
tility less than the mean volatility (i.e., RVt < RVt ) is defined as low
volatility.
The performance results under high and low volatility regimes are
reported in Table 10. Panels A and B present the results under high and
low volatility, respectively. First, in the state of high and low volatility,
most of the comprehensive indicators have the predictive ability and the
predictive ability of FAll
t is still the strongest. Second, the composite
index constructed using PCA shows superior predictive power in the low
volatility periods. By contrast, the composite index constructed using
sPCA in high volatility periods has the strongest predictive power. In
general, as volatility is higher during recessions and lowers during ex­
pansions (Choudhry, Papadimitriou, & Shabi, 2016), the high volatility
results are the same as those for recessions. Similarly, the results for low
volatility are the same as those for expansions.
6.3. Multiple-steps-ahead forecasting horizon
In addition to short-term (1-month-ahead) forecasts, investors are
also concerned about the effects of long-term forecasts. Similar to Zhang,
Ma, and Liao (2020), we forecast 3, 6, 9, and 12-month volatilities,
which can be expressed as RVt+h = 1h (RVt+1 + RVt+2 + … + RVt+h ).
Table 11 shows the results of out-of-sample R2 for different horizons.
The results illustrate obvious differences between the long-term and
short-term predictions. First, the long-term predictive ability of the EPU
index has declined, whereas that of MAI indices has improved signifi­
cantly, even exceeding that of the composite index FAll t . Second, PLS
performs better in terms of long-term forecasting and can effectively
extract long-term forecasting information.
To explain why the MAI perform better in long-term forecasting, we
Notes: This table presents the out-of-sample R2 test under high and low volatility
regimes. We classify volatility into high and low volatility using the mean of
stock volatility in the out-of-sample interval. If RVt > RVt , volatility is defined
as high volatility; otherwise, it is defined as low volatility.
consider simple unary regression prediction models, which can be
expressed as follows:
RVt+1 = α0 + βn Xn,t + εn,t+1 , (21)
where Xn, t denotes the nth MAI or EPU indices.
Fig. 6 depicts the estimated coefficients of the simple unary regres­
sion prediction models with the individual MAI or EPU indices.
Regression with a larger estimated coefficient suggests a stronger pre­
diction ability for the corresponding index. The estimated coefficients of
MAI are much larger than those of EPU indices, and the estimated co­
efficient of the EPU index is close to zero, which indicates that in the
long term, the EPU index has little impact on stock volatility, whereas
the MAI index has a greater impact on stock volatility. This further ex­
plains the strong predictive power of the MAI index in long-term
forecasting.
In addition, numerous studies show that investor attention fluctuates
over time, affecting asset prices (Andrei & Hasler, 2015; Da, Engelberg,
& Gao, 2011). The MAI reflects investor attention to different macro­
economic fundamentals. Furthermore, Acikalin, Aktas, and Unal (2008)
show a long-term relationship between stock market returns and mac­
roeconomic indicators. Therefore, unlike short-term forecasts, long-term
stock market volatility forecasts rely mainly on the MAI index, and the
EPU index contains less forecast information.
6.4. VRP estimation and return predictability
The VRP can predict medium-term aggregate returns of the stock
market (Bollerslev, Marrone, Xu, & Zhou, 2014). According to Boller­
slev, Tauchen, and Zhou (2009) and Drechsler and Yaron (2011), VRP is
closely related to economic uncertainty and aggregate risk aversion.
Consistent with Conrad and Loch (2015), we define the expected VRP as

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F. Ma et al. International Review of Financial Analysis 84 (2022) 102339

Table 11
Out-of-sample R2 tests with different horizons.
Forecasting models h=3 h=6 h=9 h = 12

R2oos (%) MSPE-Adj. p-value R2oos (%) MSPE-Adj. p-value R2oos (%) MSPE-Adj. p-value R2oos (%) MSPE-Adj. p-value

AR – – – – – –

Kitchen sink model

KS-MAI 16.648 2.643 0.004 17.193 2.022 0.022 17.022 2.499 0.006 20.459 2.495 0.006
KS-EPU − 12.817 − 0.139 0.555 − 17.838 − 2.378 0.991 − 6.837 − 1.049 0.853 4.694 1.761 0.039
KS-ALL 12.257 2.717 0.003 − 2.913 1.226 0.110 9.817 2.399 0.008 13.835 2.229 0.013

Principal component analysis model

PCA_MAI 15.818 2.621 0.004 14.782 1.901 0.029 17.011 2.517 0.006 23.845 2.523 0.006
PCA_EPU − 1.181 0.607 0.272 − 5.139 − 1.117 0.868 2.720 2.075 0.019 10.139 3.472 0.000
PCA_MAI_EPU 14.417 2.767 0.003 4.988 1.466 0.071 13.555 2.281 0.011 22.176 2.394 0.008
PCA_ALL 11.391 2.618 0.004 0.604 1.042 0.149 10.488 1.843 0.033 20.399 2.196 0.014

Scaled principal component analysis model

sPCA_MAI 12.107 2.269 0.012 1.751 1.041 0.149 6.531 1.593 0.056 14.890 1.962 0.025
sPCA_EPU 2.219 1.271 0.102 5.225 1.674 0.047 6.863 2.500 0.006 17.272 2.619 0.004
sPCA_MAI_EPU 12.053 2.644 0.004 − 0.683 1.037 0.150 9.578 1.859 0.032 19.324 2.179 0.015
sPCA_ALL 12.036 2.397 0.008 − 0.742 0.971 0.166 8.405 1.752 0.040 19.275 2.305 0.011

Partial least squares model

PLS_MAI 12.157 2.179 0.015 16.640 1.865 0.031 16.135 2.192 0.014 25.251 2.409 0.008
PLS_EPU 0.194 0.742 0.229 − 2.680 − 1.503 0.934 − 1.504 − 0.488 0.687 0.447 0.882 0.189
PLS_MAI_EPU 12.770 2.268 0.012 14.504 1.703 0.044 15.885 2.078 0.019 25.978 2.373 0.009
PLS_ALL 11.531 2.238 0.013 8.972 1.396 0.081 10.992 1.729 0.042 21.928 2.134 0.016

Notes: This table presents the out-of-sample performance of 3, 6, 9, and 12-month volatilities. A positive R2oos value indicates that the predictive model is superior to the
benchmark model.

Fig. 6. Estimated coefficients of the simple unary regression prediction models.

the difference between the square of the VIX and the conditional vari­ derived from the Chicago Board of Options Exchange.
ance forecasts from the interested models, which can be expressed as: We then evaluate the predictability of expected VRP for future stock
M
market returns using a simple linear model, which can be defined as:
VRPM 2 ̂
t = VIXt − RV t+1 , (22)
1∑ h

M
rex = ah + bh Zt + ut,t+h , (23)
where ̂
RV t+1 denotes the RV predicted by model M and the VIX index is h j=1 t+j

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F. Ma et al. International Review of Financial Analysis 84 (2022) 102339

where Zt denotes the expected VRP (VRPM ex
t ) and rt+j represents the excess
returns. Table 12 shows the OLS regression estimation results for
different horizons h. We focus on models that contain information on all
the indicators. As evident from the results, the coefficient estimates of
the expected VRP are all positive and significant for different horizons,
indicating that VRP has a forecasting ability for future stock returns. For
the 1th-, 3th-, and 6th- forecast horizons, the sPCA models generate
higher adjusted R2 values, while the PLS models generate higher
adjusted R2 values for the 9thand 12th forecast horizons. In addition, the
adjusted R2 values of the expected VRP calculated based on the RV
derived from the model with all indicator information are higher than
the initial VRP constructed from the actual volatility. This indicates that
models containing information on all indicators can successfully predict
future stock volatility from the perspectives of VRP and return
predictability.
7. Conclusion
In this study, we first explored the ability of MAI to predict stock
market volatility and further investigated whether MAI can increase
additional predictable information compared with EPU indices. Three
dimensionality-reduction methods (PCA, sPCA, PLS) were employed to
extract common information from the MAI and EPU indices, and the
corresponding composite indices FMAI , FEPU , and FAll were generated,
t t t
respectively. We introduced these composite indices into the AR model
to construct the predictive models. We found several interesting results
using the out-of-sample R2 test to examine the forecasting performance.
First, the results of the out-of-sample examination, the CSFE, and the
forecast encompassing tests showed that the combination of the MAI and
EPU indices can obtain additional information for predicting stock
market volatility. Furthermore, the composite index extracted by sPCA
was more effective than that extracted by the other methods. Second,
our results were robust to the alternative size of the forecasting windows
and alternative lags of RV. Notably, the comprehensive indices extracted
by thethree dimensionality-reduction methods still had the predictive
ability to forecast the stock market volatility of the G7 countries, and the
FAll
t index was still the strongest predictor. Third, we examined the
predictive power of these composite indicators under different economic
conditions. We found that most composite indicators still had predictive
abilities in different business cycles. Notably, the composite indices
extracted by the sPCA had the strongest predictive ability in the reces­
sion period. By contrast, the composite indices extracted by the PCA
showed the strongest predictive ability during the expansion period.
Correspondingly, the composite index constructed using PCA showed
superior predictive power in the low volatility periods. By contrast, the
composite index constructed using sPCA had the strongest predictive
power in high volatility periods. Furthermore, we examined the per­
formance of the indicators in multiple step-ahead forecasting horizons.
The results established that long-term (3, 6, 9, and 12-month-ahead)
stock market volatility forecasts mainly relied on the MAI index, and
PLS demonstrated a more efficient ability to extract information. In

Table 12
Return predictability regressions.
Variance premium Horizon 1 3 6 9 12

VRP Constant 0.581 0.546 0.578 0.520 0.558

(2.407) (3.890) (5.572) (5.772) (6.906)
VRP 0.005 0.007 0.002 0.006 0.003
(0.753) (1.879) (0.875) (1.917) (0.904)
Adj. R2 0.172 1.068 0.236 1.132 0.256
VRPKS_All Constant 0.109 0.231 0.335 0.446 0.514
(0.413) (1.519) (2.999) (4.590) (5.855)
VRP 0.039 0.029 0.021 0.011 0.006
(3.965) (5.011) (4.864) (2.746) (1.562)
Adj. R2 4.561 7.131 6.806 2.295 0.762
VRPPCA_MAI_EPU Constant 0.081 0.163 0.264 0.403 0.476
(0.283) (0.992) (2.199) (3.889) (5.074)
VRP 0.039 0.033 0.025 0.014 0.008
(3.285) (4.623) (4.844) (2.933) (1.914)
Adj. R2 3.175 6.134 6.754 2.609 1.139
VRPPCA_All Constant 0.023 0.142 0.289 0.436 0.512
(0.081) (0.890) (2.455) (4.306) (5.579)
VRP 0.045 0.035 0.024 0.012 0.006
(3.883) (5.182) (4.750) (2.550) (1.374)
Adj. R2 4.382 7.589 6.511 1.985 0.590
VRPsPCA_MAI_EPU Constant 0.077 0.209 0.331 0.459 0.523
(0.300) (1.415) (3.044) (4.890) (6.171)
VRP 0.045 0.033 0.023 0.011 0.006
(4.609) (5.855) (5.437) (2.873) (1.589)
Adj. R2 6.066 9.489 8.361 2.507 0.787
VRPsPCA_All Constant 0.034 0.155 0.281 0.431 0.502
(0.127) (1.007) (2.481) (4.382) (5.640)
VRP 0.048 0.038 0.027 0.013 0.007
(4.213) (5.596) (5.450) (2.913) (1.727)
Adj. R2 5.120 8.738 8.397 2.576 0.929
VRPPLS_MAI_EPU Constant 0.282 0.287 0.295 0.398 0.458
(0.978) (1.712) (2.431) (3.829) (4.848)
VRP 0.026 0.025 0.024 0.015 0.010
(2.008) (3.214) (4.276) (2.956) (2.197)
Adj. R2 1.211 3.063 5.343 2.649 1.495
VRPPLS_All Constant 0.266 0.269 0.296 0.403 0.468
(0.912) (1.593) (2.415) (3.825) (4.875)
VRP 0.027 0.026 0.024 0.014 0.009
(2.057) (3.318) (4.141) (2.771) (1.955)
Adj. R2 1.270 3.256 5.027 2.337 1.187

Notes: This table reports the VRP coefficient estimates for different horizons. The values in parentheses are t-statistics. The numbers in bold represent the highest Adj.
R2 values for each horizon.

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F. Ma et al. International Review of Financial Analysis 84 (2022) 102339

addition, the results of the VRP estimation further illustrated that the
model including all indicators had stronger predictive power.
Overall, our results suggested that MAI and EPU indices provide
complementary information for predicting stock market volatility.
Furthermore, we provided strong evidence that different
dimensionality-reduction methods should be used in different situa­
tions. Simultaneously, we demonstrated that the indicator's predictive
ability differs for different forecast horizons. This study is of great sig­
nificance in predicting stock market volatility under different
circumstances.
Conflicts of interest
We declare that there is not conflict of interest.
Acknowledgments
The authors are grateful to the editor and anonymous referees for
insightful comments that significantly improved the paper. This work is
supported by the Natural Science Foundation of China [72071162], the
Natural Science Foundation of Sichuan Province [2022NSFSC0917].

Appendix

To illustrate the specific content of the principal components, the appendix reports the estimated principal components extracted by sPCA, PCA,
and PLS and the estimated loadings of individual variables on the principal components.
Figs. A1–A6 present the principal components extracted using the PCA.
Figs. A7–A12 present the principal components extracted using the sPCA.
Figs. A13–A18 present the principal components extracted using the PLS.

Fig. A1. Principal components extracted from MAI using PCA.

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F. Ma et al. International Review of Financial Analysis 84 (2022) 102339

Fig. A2. Loadings on principal components extracted from MAI using PCA.

Fig. A3. Principal components extracted from EPU indices using PCA.

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F. Ma et al. International Review of Financial Analysis 84 (2022) 102339

Fig. A4. Loadings on principal components extracted from EPU indices using PCA.

Fig. A5. Principal components extracted from MAI and EPU indices using PCA.

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F. Ma et al. International Review of Financial Analysis 84 (2022) 102339

Fig. A6. Loadings on principal components extracted from MAI and EPU indices using PCA.

Fig. A7. Principal components extracted from MAI using sPCA.

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F. Ma et al. International Review of Financial Analysis 84 (2022) 102339

Fig. A8. Loadings on principal components extracted from MAI indices using sPCA.

Fig. A9. Principal components extracted from EPU indices using sPCA.

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F. Ma et al. International Review of Financial Analysis 84 (2022) 102339

Fig. A10. Loadings on principal components extracted from EPU indices using sPCA.

Fig. A11. Principal components extracted from MAI and EPU indices using sPCA.

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F. Ma et al. International Review of Financial Analysis 84 (2022) 102339

Fig. A12. Loadings on principal components extracted from MAI and EPU indices using sPCA.

Fig. A13. Principal components extracted from MAI using PLS.

Fig. A14. Loadings on principal components extracted from MAI using PLS.

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F. Ma et al. International Review of Financial Analysis 84 (2022) 102339

Fig. A15. Principal components extracted from EPU indices using PLS.

Fig. A16. Loadings on principal components extracted from EPU indices using PLS.

Fig. A17. Principal components extracted from MAI and EPU indices using PLS.

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F. Ma et al. International Review of Financial Analysis 84 (2022) 102339

Fig. A18. Loadings on principal components extracted from MAI and EPU indices using PLS.

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