Industry Return Predictability: A Machine Learning Approach

In this article, the authors use machine learning tools to analyze industry return predictability based on the information in lagged industry returns. Controlling for post-selection inference and multiple testing, they find significant in-sample evidence of industry return predictability. Lagged returns for the financial sector and com-modity-and material-producing industries exhibit widespread predictive ability, consistent with the gradual diffusion of information across economically linked industries. Out-of-sample industry return forecasts that incorporate the information in lagged industry returns are economically valu-able: Controlling for systematic risk using leading multifactor models from the literature, an industry-rotation portfolio that goes long (short) industries with the highest (lowest) forecasted returns delivers an annualized alpha of over 8%. The industry-rotation portfolio also generates substantial gains during economic downturns, including the Great Recession.