Reconciling the Return Predictability Evidence
Stijn Van Nieuwerburgh
New York University Stern School of Business, Department of Finance; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)
University of California - Haas School of Business; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)
March 3, 2006
AFA 2007 Chicago Meetings Paper
Evidence of stock return predictability by financial ratios is still controversial, as documented by inconsistent results for in-sample and out-of-sample regressions and by substantial parameter instability. This paper shows that these seemingly incompatible results can be reconciled if the assumption of a fixed steady-state mean of the economy is relaxed. We find strong empirical evidence in support of shifts in the steady-state and propose simple methods to adjust financial ratios for such shifts. The forecasting relationship of adjusted price ratios and future returns is statistically significant and stable over time. We also show that shifts in the steady-state are responsible for the parameter instability and poor out-of-sample performance of unadjusted price ratios that are found in the data. Our conclusions hold for a variety of financial ratios and are robust to changes in the econometric technique used to estimate shifts in the steady-state.
Number of Pages in PDF File: 50
Keywords: return predictability, structural breaks
JEL Classification: G00, G10, G14, C22working papers series
Date posted: March 3, 2006
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