Modeling Stock Market Returns

In this article, the authors develop a two–step econometric model to explain and forecast stock market movements in seventeen countries. Their key assumption is that while a theory such as the dividend discount model is relevant to explain the long–run behavior of stock markets, short–run fluctuations are driven by variables that do not enter into the theory of cointegration and error correction for developing the two–step model for long–term behavior and short–term behavior. They present in– and out–of a sample tests of the model's ability to forecast future stock market results. These results indicate that such a model does have predictive power and can thus be a useful tool in the investment decision process.