Abstract

This paper introduces a two-stage out-of-sample predictive model averaging approach to forecasting the U.S. market equity premium. In the first stage, we combine the break and stable specifications for each candidate model utilizing schemes such as Mallows weights to account for the presence of structural breaks. Next, we combine all previously averaged models by equal weights to address the issue of model uncertainty. Our empirical results show that the double-averaged model can deliver superior statistical and economic gains relative to not only the historical average but also the simple forecast combination when forecasting the equity premium. Moreover, our approach provides an explicit theory-based linkage between forecast combination and structural breaks which distinguishes this study from other closely related works.

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