Reconciling the Return Predictability Evidence In-Sample Forecasts, Out-of-Sample Forecasts, and Parameter Instability

55 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: January 2012

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 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.

Suggested Citation

Lettau, Martin and Van Nieuwerburgh, Stijn, Reconciling the Return Predictability Evidence In-Sample Forecasts, Out-of-Sample Forecasts, and Parameter Instability (January 2012). NYU Working Paper No. 2451/31432, Available at SSRN: https://ssrn.com/abstract=1294613

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