Equity return predictability in Northern European stock exchange markets

Abstract

This thesis presents an analysis of equity return predictability in the stock markets of Norway, Sweden, Denmark and Finland. In consumption-based asset pricing theory, the investment decisions of an average investor are driven by the desire to increase consumption and smooth it across time periods. All multifactor models build upon this idea and include factors which are thought to affect the investors’ riskiness of consumption and/or their risk aversion. We test if equity returns are predictable by the three country-level macroeconomic factors: income growth, relative unemployment and house price index growth. Changes in these variables indicate local economic expansions and contractions which we believe affect an average investor’s risk-sharing decisions and stock price level in the country. We also control for the effect of the same indicators on the Euro zone level, as well as interest rate spreads, dividend yield and the consumption-wealth ratio, which have been found to predict stock returns in earlier research. We construct a panel data set containing the four countries’ all-share index excess returns, the country-level and Euro zone-level macroeconomic predictors and other controls for the period 2000 to 2016. We estimate a fixed effects regression using Driscoll and Kraay standard errors, which are robust to heteroscedasticity, autocorrelation and cross-sectional dependence present in our sample. According to our results, lower country-level income growth and higher relative unemployment, which are indicative of a local recession, are significant predictors of higher future excess stock returns on all-share indices in Oslo, Stockholm, Copenhagen and Helsinki.