In this paper we provide compelling evidence of cyclical mean reversion and multiperiod stock return predictability over horizons of about 30 years with a half-life of about 15 years. This implies that the US stock market follows a long-term rhythm where a period of above average returns tends to be followed by a period of below average returns. We demonstrate that this long-term stock market rhythm moves in lockstep with corresponding long-term economic, social, and political rhythms in the US. Assuming that the past relationship between these rhythms will hold unaltered in the future, we provide the medium to long-term stock market outlook.
In particular, the first contribution of this paper is to provide statistically significant evidence against the random walk hypothesis over horizons longer than 25 years. Our findings speak in favor of cyclical mean reversion in stock prices over horizons of 24-36 years. The second contribution of this paper is to present the evidence of both in-sample and out-of-sample predictability of multiperiod stock return. In particular, we find statistically significant evidence of in-sample predictability of multiperiod returns which roughly says that a period of above average returns tends to be followed by a period (of about the same length) of below average returns.
In our opinion, we are currently in the beginning of a new liberal era. Consequently, this provides a pessimistic medium-term stock market outlook. Nevertheless, each liberal era is eventually replaced by a conservative era. Our rough estimate is that we need to wait for at least a decade for the next conservative era and an optimistic long-term stock market outlook.
Well that's grim.
http://arxiv.org/abs/1203.2250
Author is from University of Agder - Faculty of Economics, Norway
