Option-implied idiosyncratic skewness and expected returns: Mind the long run

This article examines the time-series predictive ability of the monthly option-implied idiosyncratic skewness ($Skew$) for the aggregate stock market. We find that $Skew$ is a strong predictor of the U.S. equity premium using both in-sample and out-of-sample tests at forecast horizons up to 36 months over the period from January 1996 to December 2021. In comparison, $Skew$ outperforms the previously used financial and macroeconomic variables. Furthermore, combining information in the transitional predictors with $Skew$ can further improve the forecasting performance than using $Skew$ alone. We provide two explanations for the documented predictability. First, $Skew$ exhibits strong procyclical behavior and consistently declines ahead of economic downturns. Second, $Skew$ acts as a forward-looking signal of investor sentiment and disagreement—positive shocks to $Skew$ significantly increase both future investor sentiment and disagreement, with effects that persist over several horizons.