Industry portfolios, information diffusion and the predictability of stock returns in Kenya

A Research project Submitted in partial fulfillment of the requirements for the degree of Bachelor of Business Science in Financial Economics at Strathmore UniversityThis paper tests the hypothesis that stock return predictability exists in the Kenyan market. In particular, it investigates whether in the presence of gradual information diffusion, which is as a result of investors’ limited information processing ability, lagged industry portfolios excess returns are able to predict the NSE 20 stock market index excess returns, which serves as a proxy for the entire stock market. Five market capitalization weighted industry portfolios, namely Agriculture, Financial Services, Commercial and Services, Manufacturing and Energy and Transport are constructed using stock returns from the year 2005 to 2015. The lagged industry portfolio expected returns, the market expected returns and the industry portfolio residuals (both lagged and for the current period) are fitted into an information diffusion model and thereafter the industry predictability and information diffusion coefficients are estimated using the Arellano-Bond GMM Estimator. The findings suggest that there is no causal relationship between the industries and the stock market and no gradual information diffusion. This implies that for the Kenyan stock market, there is no stock return predictability when the analysis is performed using the industry and wider stock market approach