Does Debt Ceiling and Government Shutdown Help in Forecasting the US Equity Risk Premium?

Abstract

This article evaluates the predictability of the equity risk premium in the United States by comparing the individual and complementary predictive power of macroeconomic variables and technical indicators using a comprehensive set of 16 economic and 14 technical predictors over a monthly out-of-sample period of 1995:01 to 2012:12 and an in-sample period of 1986:01-1994:12. In order to do so we consider, in addition to the set of variables used in Christopher J. Neely et al. (2013) and using a more recent dataset, the forecasting ability of two other important variables namely government shutdown and debt ceiling. Our results show that one of the newly added variables namely government shutdown provides statistically significant out-of-sample predictive power over the equity risk premium relative to the historical average. Most of the variables, including government shutdown, also show significant economic gains for a risk averse investor especially during recessions.

Key words: Equity risk premium forecasting, Debt ceiling, Government shutdown, Out-of-sample forecasts, Asset allocation.
JEL: C38, C53, C58, E32, G11, G12, G17.