A recursive modelling approach to predicting UK stock returns

This paper applies an extended and generalized version of the recursive modelling strategy developed in Pesaran and Timmermann (1995) to the UK stock market. The focus of the analysis is to stimulate investors' search in 'real time' for a model that can forecast stock returns. It demonstrates the extent to which monthly stock returns in the UK were predictable over the period 1970-1992 after allowing for model specification uncertainty and possible shifts in the forecasting model. Due to a set of unique historical circumstances, UK stock returns were extremely volatile in 1974-1975, and we discuss how to design a modelling approach capable of accounting for this and similar low probability events. We find evidence of predictability in UK stock returns which could have been exploited by investors to improve on the risk-return trade-off offered by a passive strategy in the market portfolio. Alternative interpretations of this finding are briefly discussed.