Predicting returns in US financial sector indices

This study focuses on: (i) the responsiveness of the US financial sector stock indices to foreign exchange (FX) and interest rate changes; and, (ii) the extent to which good model specification can enhance the forecasts from the associated models. Three models are considered. Only the error-correction model (ECM) generated efficient and consistent coefficient estimates. Furthermore, a simple zero lag model in differences which is clearly mis-specified, generated forecasts that are better than those of the ECM, even if the ECM depicts relationships that are more consistent with economic theory. In brief, FX and interest rate changes do not impact on the return-generating process of the stock indices in any substantial way. Most of the variation in the sector stock indices is associated with past variation in the indices themselves and variation in the market-wide stock index. These results have important implications for financial and economic policies.