houston voices

Houston research: Can predictive tools help forecast the stock market?

The stock market has always been hard, if not impossible, to forecast. Image via Getty Images

What do you think the Standard & Poor’s 500 index will do over the next year?

When Rice Business finance professor Kevin Crotty asks his MBA students this question, the answers are all over the map. Some students expect the overall return on the stock market to be 10 percent, while others predict a loss of 20 percent.

This guessing game is closer to real life than many people realize. Experienced investors, people who have watched the stock market ebb and flow for many years, know that making predictions is a risky business. “Many money managers are more confident choosing individual stocks than trying to time the market,” says finance professor Kevin Crotty.

For most of the past century, academics have applied their power of analysis to understanding and predicting the stock market. Recently, some finance researchers have taken a closer look at option prices—the price paid for the right to buy or sell a security (like a stock or bond) at a specified price in the future. Combining economic theory with high-frequency options price data, they argued that they could estimate the expected return on the market in real-time, which would represent a tremendous development for finance practitioners and academics alike.

Crotty teamed up with Kerry Back, a fellow Rice Business professor, and Seyed Mohammad Kazempour, a finance Ph.D. student at the Jones Graduate School of Business, to evaluate whether the new predictors based on option prices really are a valuable forecasting tool. “Options are essentially a forward-looking contract, so it’s possible that they could be used to create a forward-looking measure of expected returns,” says Kazempour.

Economic theory suggests that the new predictors might systematically underestimate expected returns. The team set out to test if this may be the case, and if so, whether the predictors are useful as a forecasting tool. In their paper, “Validity, Tightness, and Forecasting Power of Risk Premium Bounds,” the Rice Business researchers ran the predictors through a more rigorous set of statistical tests that provide more power to detect whether the predictors systematically underestimate expected returns. The statistical tests used in previous research on the topic were less stringent, leading to conclusions that the predictors do not underestimate expected returns.

In short, the new predictors didn’t pass the more stringent tests. The researchers found that forecasts built on stock options consistently underestimated market returns. Moreover, the predictors are enough of an underestimate that they are not very useful as forecasts of market returns.

The results were somewhat anticlimatic, the researchers admit. If the option-based predictors had panned out, it could have become an innovative new tool for thinking about market timing for asset managers as well as investment decision-making for corporate finance projects. “Trying to estimate expected market returns is closely related to whether corporations decide to invest in projects,” notes Crotty. “The expected market return is an input in estimating the cost of capital when evaluating projects, and I explain in my MBA courses that we don’t have very precise estimates for this input. During this research project, I kept thinking about how cool it would be if we really had a better estimate,” he says.

Their research doesn’t end here. Crotty and Back have already begun brainstorming ways to potentially improve the option-based forecasting tool so that it can become more accurate.

At best, though, using option prices as a forecasting tool will only be one ingredient out of many that investors use to make decisions. “This tool may inform money management, but it will never drive it,” says Back.

For now, at least, the Rice researchers believe that trying to predict the stock market is still a very risky game.

------

This article originally ran on Rice Business Wisdom and was based on research from Rice Professors Kerry Backand Kevin Crotty.

Trending News

Building Houston

 
 

HOUSTON INNOVATORS PODCAST EPISODE 162

Houston innovator on seeing a greener future on built environment

INOVUES Founder and CEO Anas Al Kassas joins the Houston Innovators Podcast to discuss how he’s moving the needle on the energy transition within the construction and architectural industries. Photo courtesy of INOVUES

An architect by trade, Anas Al Kassas says he was used to solving problems in his line of work. Each project architects take on requires building designers to be innovative and creative. A few years ago, Kassas took his problem-solving background into the entrepreneurship world to scale a process that allows for retrofitting window facades for energy efficiency.

“If you look at buildings today, they are the largest energy-consuming sector — more than industrial and more than transportation,” Kassas, founder and CEO of INOVUES, says on the Houston Innovators Podcast. “They account for up to 40 percent of energy consumption and carbon emissions.”

To meet their climate goals, companies within the built environment are making moves to transition to electric systems. This has to be done with energy efficiency in mind, otherwise it will result in grid instability.

"Energy efficiency goes hand in hand with energy transition," he explains.

Kassas says that he first had the idea for his company when he was living in Boston. He chose to start the business in Houston, attracted to the city by its central location, affordable labor market, and manufacturing opportunities here.

Last year, INOVUES raised its first round of funding — a $2.75 million seed round — to scale up the team and identify the best markets to target customers. Kassas says he was looking for regions with rising energy rates and sizable incentives for companies making energy efficient changes.

"We were able to now implement our technology in over 4 million square feet of building space — from Boston, Seattle, Los Angeles, New York City, Portland, and very soon in Canada," he says.

Notably missing from that list is any Texas cities. Kassas says that he believes Houston is a great city for startups and he has his operations and manufacturing is based here, but he's not yet seen the right opportunity and adaption

"Unfortunately most of our customers are not in Texas," "A lot of work can be done here to incentivize building owners. There are a lot of existing buildings and construction happening here, but there has to be more incentives."

Kassas shares more about his growth over the past year, as well as what he has planned for 2023 on the podcast. Listen to the interview below — or wherever you stream your podcasts — and subscribe for weekly episodes.

Trending News