A Causal Perspective of Stock Prediction Models

In the realm of stock prediction, machine learning models encounter considerable obstacles due to the inherent low signal-to-noise ratio and the nonstationary nature of financial markets. These challenges often result in spurious correlations and unstable predictive relationships, leading to poor performance of models when applied to out-of-sample (OOS) domains. To address these issues, we investigate $\mathit{\text{Domain}}\mathit{\text{Generalization}}$ techniques, with a particular focus on causal representation learning to improve a prediction model’s generalizability to OOS domains. By leveraging multi-factor models from econometrics, we introduce a novel error bound that explicitly incorporates causal relationships. In addition, we present the connection between the proposed error bound and market nonstationarity. We also develop a $\mathit{\text{Causal}}\mathit{\text{Discovery}}$ technique to discover invariant feature representations, which effectively mitigates the proposed error bound, and the influence of spurious correlations on causal discovery is rigorously examined. Our theoretical findings are substantiated by numerical results, showcasing the effectiveness of our approach in enhancing the generalizability of stock prediction models.