Blog - Investing Notes

April 21, 2006 - Predicting Stock Returns Not with Volatility, But Volatilities

Conventional wisdom holds that high (low) overall stock market volatility forecasts high (low) stock returns, as a fundamental reward-for-risk phenomenon. However, analysis shows that this volatility-returns relationship is (for implied volatility) unreliable, with only an extremely high overall market volatility usefully predictive. In their March 2006 paper entitled "Understanding Stock Return Predictability", Hui Guo and Robert Savickas investigate a refinement to volatility-based prediction of stock market returns by combining the effects of realized overall market volatility and the average realized idiosyncratic volatility of individual stocks. They theorize that: (1) overall stock market volatility reflects the volatilities of both cash flow shocks and discount rate shocks; (2) overall stock market volatility overstates discount rate shock volatility; and, (3) average idiosyncratic volatility, which reflects the volatility of discount rate shocks only, corrects this overstatement. Using quarterly overall and idiosyncratic volatilities from 1927 through 2005, they conclude that:

• Used together, overall stock market volatility and average idiosyncratic volatility reliably forecast stock market returns during 1927-2005.
• The predictive power of the combined volatility measures is stable across time, holding for subsample periods.
• The predictive power of the combined volatility measures also holds after controlling for a range of other variables.
• Individually, while overall stock market volatility relates positively to future returns, average idiosyncratic volatility relates negatively. These differing relationships suggest that investors use the overall market as a hedge for individual equity investments.
• Neither overall stock market volatility nor average idiosyncratic volatility alone reliably forecasts stock market returns.
• For data available over the period 1963-2005, the value premium correlates closely with idiosyncratic volatility.

In summary, when experts cite overall stock market volatility as an indicator of future market behavior, they are only half right, which is about the same as wrong.

The authors suggest that "investors cannot easily exploit the stock return predictability documented in this paper because it reflects systematic risk." They also explain why the dividend yield does not reliably predict stock returns.

Although their perspectives are different, we note some similarities between our stock market models and the authors' volatility analysis. Our Real Earnings Yield Model describes the behavior of the overall stock market in terms of operating earnings (related to cash flows) and inflation (related to the discount rate). Our parameterization of this model gives more weight to changes in earnings than to changes in inflation.

For related research, see Blog Synthesis: Volatility Effects.