Reconciling the Return Predictability Evidence
52 Pages Posted: 3 Nov 2008
Date Written: April 2006
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 in-sample forecasting relationship of adjustedprice ratios and future returns is statistically significant and stable over time. In real-time,however, changes in the steady-state make the in-sample return forecast ability hard to exploit out-of-sample. The uncertainty of estimating the size of steady-state shifts rather thanthe estimation of their dates is responsible for the difficulty of forecasting stock returns in real-time. 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.
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