Forecasting stock indices: a comparison of classification and level estimation models

Despite abundant research which focuses on estimating the level of return on stock market index, there is a lack of studies examining the predictability of the direction/sign of stock index movement. Given the notion that a prediction with little forecast error does not necessarily translate into capital gain, we evaluate the efficacy of several multivariate classification techniques relative to a group of level estimation approaches. Specifically, we conduct time series comparisons between the two types of models on the basis of forecast performance and investment return. The tested classification models, which predict direction based on probability, include linear discriminant analysis, legit, probit, and probabilistic neural network. On the other hand, the level estimation counterparts, which forecast the level, are exponential smoothing, multivariate transfer function, vector autoregression with Kalman filter, and multilayered feedforward neural network. Our comparative study also measures the relative strength of these models with respect to the trading profit generated by their forecasts. To facilitate more effective trading, we develop a set of threshold trading rules driven by the probabilities estimated by the classification models. Empirical experimentation suggests that the classification models outperform the level estimation models in terms of predicting the direction of the stock market movement and maximizing returns from investment trading. Further, investment returns are enhanced by the adoption of the threshold trading rules. (C) 2000 Elsevier Science B.V. All rights reserved.