Regime Specific Predictability in Predictive Regressions
32 Pages Posted: 17 Feb 2011 Last revised: 3 Mar 2011
Date Written: December 24, 2010
Predictive regressions are linear specifications linking a noisy variable such as stock returns to past values of a more persistent regressor with the aim of assessing the presence of predictability. Key complications that arise are the potential presence of endogeneity and the poor adequacy of asymptotic approximations. In this paper we develop tests for uncovering the presence of predictability in such models when the strength or direction of predictability may alternate across different economically meaningful episodes. An empirical application reconsiders the Dividend Yield based return predictability and documents a strong predictability that is countercyclical, occurring solely during bad economic times.
Keywords: Endogeneity, Persistence, Return Predictability, Threshold Models
JEL Classification: C22, C50
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