Financial Variables and the Predictability of Stock and Bond Returns: An Out-of-Sample Analysis

Most studies of the predictability of stock and bond returns rely on in-sample tests. In this paper, we test the ability of ten financial variables that have appeared in the extant literature to predict S&P 500 and CRSP equal-weighted stock returns out-of-sample over horizons of 1-10 years. We also test the ability of two financial variables, the term and default spreads, to predict long-term corporate bond real returns outof-sample. For S&P 500 returns, we identify three variables with out-of-sample predictive ability: the equity share in total new debt and equity issues, term spread, and market value-to-net worth ratio (“Fed q”). For CRSP equal-weighed returns, we find that the dividend yield, price-earnings ratio, Fed q, and equity share all exhibit significant out-of-sample predictive power. In addition, the default spread exhibits significant out-of-sample predictive power for long-term corporate bond returns. As out-ofsample tests of predictive ability raise the bar relative to in-sample tests, our results strengthen the case for stock and bond return predictability. JEL classifications: C22, C52, C53, G12, G14