University of Michigan
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NBER Working Papers and Publications
|November 2017||Shrinking the Cross Section|
with Stefan Nagel, Shrihari Santosh: w24070
We construct a robust stochastic discount factor (SDF) that summarizes the joint explanatory power of a large number of cross-sectional stock return predictors. Our method achieves robust out-of-sample performance in this high-dimensional setting by imposing an economically motivated prior on SDF coefficients that shrinks the contributions of low-variance principal components of the candidate factors. While empirical asset pricing research has focused on SDFs with a small number of characteristics-based factors—e.g., the four- or five-factor models discussed in the recent literature—we find that such a characteristics-sparse SDF cannot adequately summarize the cross-section of expected stock returns. However, a relatively small number of principal components of the universe of potential ch...
|September 2017||Predicting Relative Returns|
with Valentin Haddad, Shrihari Santosh: w23886
Across a variety of asset classes, we show that relative returns are highly predictable in the time series in and out of sample, much more so than aggregate returns. For Treasuries, slope is more predictable than level. For equities, dominant principal components of anomaly long-short strategies are more predictable than the market. For foreign exchange, a carry portfolio is more predictable than a basket of all currencies against the dollar. We show the commonly used practice to predict each individual asset is often equivalent to predicting only their first principal component, the index, which obscures the predictability of relative returns. Our findings highlight that focusing on important dimensions of the cross-section allows one to uncover additional economically relevant and statis...