Modeling stock market returns -: An error correction model.

In this article, the authors develop a two-step econometric model to explain and forecast stock market movements in seventeen countries. Their key assumption is that while a theory such as the dividend discount model is relevant to explain the long-run behavior of stock markets, shortrun fluctuations are driven fry variables that do not enter into the theory, and thus have to be empirically determined. This leads the authors to base their model on the theory of cointegration and error correction for developing the two-step model for long-term behavior and shortterm behavior. They present in- and out-of-sample tests of the model's ability to forecast future stock market results. These results indicate that such a model does have predictive power and can thus be a useful tool in the investment decision process.