Abstract
This study examines the predictability of excess stock returns in the New Zealand stock market over the period May 1992 to February 2011, and particularly whether there exists a spill-over effect from developed markets to the New Zealand market. Consistent with the findings in US studies, the combination forecast proposed by Rapach, Strauss and Zhou (2010) gives reliably more accurate excess return forecasts than the historical mean strategy. This superior out-of-sample forecast performance over the benchmark is both statistically and economically significant and heightened during recessions. In order to test for a spill-over effect from developed markets to the New Zealand market, US and Australian market returns are introduced and also VIX, a measure of market risk appetite. These international factors contribute significantly to the out-of-sample forecasts at short horizons even after controlling for the effect of local factors. The importance of these predictors demonstrates a spill-over effect, revealing how different markets are subject to the same risk through market integration, and economic news is reflected quickly in the more liquid markets, which then transmits to smaller and less liquid markets. This spill-over effect becomes strikingly important during the global financial crisis, which shows the existence of a contagion effect. Further evidence for this is established by comparing the predictability in small-capitalization stocks with that in large-capitalization stocks. Finally, the Cochrane and Piazzesi (2005) factor, a useful predictor in the US market, is not useful for return prediction in the New Zealand market.