Economic factors and the stock market: a new perspective

It has been widely accepted that many financial and economic variables are non‐linear, and neural networks can model flexible linear or non‐linear relationships among variables. The present paper deals with an important issue: Can the many studies in the finance literature evidencing predictability of stock returns by means of linear regression be improved by a neural network? We show that the predictive accuracy can be improved by a neural network, and the results largely hold out‐of‐sample. Both the neural network and linear forecasts show significant market timing ability. While the switching portfolio based on the linear forecasts outperforms the buy‐and‐hold market portfolio under all three transaction cost scenarios, the switching portfolio based on the neural network forecasts beats the market only if there is no transaction cost. Copyright © 1999 John Wiley & Sons, Ltd.