Reconciling the Return Predictability Evidence

52 Pages Posted: 3 Nov 2008

See all articles by Martin Lettau

Martin Lettau

University of California - Haas School of Business; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Stijn Van Nieuwerburgh

Columbia University Graduate School of Business; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR); ABFER

Multiple version iconThere are 4 versions of this paper

Date Written: April 2006

Abstract

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.

Suggested Citation

Lettau, Martin and Van Nieuwerburgh, Stijn, Reconciling the Return Predictability Evidence (April 2006). NYU Working Paper No. FIN-06-013, Available at SSRN: https://ssrn.com/abstract=1293645

Martin Lettau (Contact Author)

University of California - Haas School of Business ( email )

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Stijn Van Nieuwerburgh

Columbia University Graduate School of Business ( email )

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