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16-10-2017 | Original Research | Issue 2/2018

Review of Quantitative Finance and Accounting 2/2018

Stock market return predictability: Does network topology matter?

Journal:
Review of Quantitative Finance and Accounting > Issue 2/2018
Author:
Harnchai Eng-Uthaiwat

Abstract

This paper provides new evidence for the predictability of excess market portfolio returns using a network approach. In particular, this article introduces a measure of interconnectedness to capture the interrelationship of returns of 100 largest stocks in S&P500 during 1990–2014. In the financial network literature, the interconnection of a stock network is often regarded as a channel through which an idiosyncratic shock propagates. The idiosyncratic risk propagation is crucial to the debate over the relationship between idiosyncratic risk and market returns because the idiosyncratic risk is not always diversified away. Rather, the network can sometimes amplify the effect of the idiosyncratic risk to cause aggregate fluctuation. In accordance with this theoretical argument, I empirically show that the network topology, measured by diameter, works together with the idiosyncratic risk, measured by average stock variance, to affect the market portfolio returns. This relationship persists after controlling for well-known variables known to forecast the stock market returns.

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