Reconciling the Return Predictability Evidence In-Sample Forecasts, Out-of-Sample Forecasts, and Parameter Instability*
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)
December 13, 2005
8th Annual Texas Finance Festival
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 relationships of adjusted price ratios and future returns is statistically significant, stable over time, and present in out-of-sample tests. 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: 55working papers series
Date posted: April 8, 2006
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