Fundamental index aligned and excess market return predictability

Abstract

We document the significant predictive power of an aligned fundamental index for aggregate excess stock market returns. The index incorporates the major financial indicators used by Piotroski (2000) and eliminates the idiosyncratic error components of individual indicators using the partial least squares approach modified by Kelly and Pruitt (2015). Our proposed fundamental index outperforms the aggregate financial score index of Piotroski (2000) and the equally weighted financial index in predicting returns for both in‐sample and out‐of‐sample tests. The aligned financial index also provides significant forecasting power for future market returns after controlling for the major economic variables. The proposed index persistently exhibits strong return forecasting power for longer time horizons and generates higher certainty equivalent gain for risk‐averse investors. The positive relations between the proposed index and future returns of portfolios sorted by momentum, book‐to‐market ratio, and company size are all significant.