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This article examines the nature of time variation within the stock return predictive regression for the United Kingdom. We consider six predictor variables but find significant in-sample evidence of predictive power for only three: the bond-equity yield ratio, the dividend yield and the price-earnings ratio, and out-of-sample evidence for the latter two. Notwithstanding this, we are able to identify substantial evidence of time variation within predictive power for all variables. However, such time variation is only linked to the state of the macroeconomy for the same three variables. Nonetheless, we are able to identify macroeconomic regimes where predictability for each of these three variables is stronger. Specifically, predictive power is stronger for the bond-equity yield ratio when output is rising and stronger for the dividend yield and price-earnings ratio when output is falling. We can use this information to build an improved prediction model by allowing for the variables, including AR terms, to enter the model according to the state of the world. However, we are still unable to beat the market in an out-of-sample forecast exercise, except with the bond-equity yield and with a mix of this variable and an AR(1). Nonetheless, the results do point to the conclusion that stock market predictability is present for the United Kingdom and that it is time-varying, the knowledge of which can improve the forecast models.
