Free PDF Ebooks Files @AcrobatPlanet.Com

Predictability of asset returns has immediate interest for investment practitioners and farreaching implications for the efficacy of asset prices in allocating capitals. Focus in this literature has been on the predictability of the level or conditional mean of asset returns (e.g., Fama 1970, 1991, Jegadeesh 1990, Lo and MacKinlay 1999, Poterba and Summers 1988). In this paper, we investigate the predictability of the direction of changes in economic variables, such as interest rates, inflation rates, exchange rates and stock prices.

The direction of changes in economic variables may be a reasonable proxy for a utility-based measure of forecasting performance. Leitch and Tanner (1991, 1995) find that the direction-of-change criterion is the best proxy among several commonly used criteria for choosing forecasts of interest rates on their ability to maximize expected trading profits. There exist important circumstances under which the direction-of-change criterion is exactly the right one for maximizing the economic welfare (e.g., profit) of the forecaster, as is nicely demonstrated in Granger and Pesaran (1999, Sections 2-4) and Leitch and Tanner (1995) from a perspective of decision-making under uncertainty. In finance, directional predictability in asset returns has important implications for market timing, which is crucial for active asset allocation management. In Merton’s (1981) classical market timing model, mutual fund managers care about the direction of excess returns, rather than their magnitude.