FORECASTING STOCK RETURNS - AN EXAMINATION OF STOCK-MARKET TRADING INTHE PRESENCE OF TRANSACTION COSTS

The paper presents new evidence on the predictability of excess return s on common stocks for the Standard and Poor's 500 and the Dow Jones I ndustrial portfolios at the monthly, quarterly, and annual frequencies . It shows that recursive predictions obtained on the basis of the exc ess returns regressions are capable of correctly predicting a statisti cally significant proportion of the signs of the actual returns. The p aper also shows that the switching portfolios constructed on the basis of the signs of the recursive predictions mean-variance dominate the respective market portfolios when trading takes place on a quarterly o r annual basis. This result holds even under a high transaction cost s cenario. However, due to the larger number of transactions at the mont hly frequency the monthly switching portfolios only mean-variance domi nate the respective market portfolios when transaction costs are zero or low.