Return Predictability Under the Alternative
54 Pages Posted: 26 Aug 2012 Last revised: 3 Dec 2013
Date Written: November 22, 2013
Long-horizon predictability is not a myth. We propose a new analytical standard error for predictive regressions that does not impose the null hypothesis that returns are unpredictable and exhibits substantial power gains relative to popular tests. Deriving the covariance matrix under the alternative hypothesis produces two new terms capturing the volatility of shocks to the regressor and their correlation with shocks to the prediction equation. Empirically, we show that failure to detect long-horizon predictability comes from lower power in tests derived under the null hypothesis. For many predictors, giving the alternative a chance allows short-run predictability to survive at long-horizons.
Keywords: Predictability, overlapping observations, analytical standard errors, size, power
JEL Classification: G12, C52
Suggested Citation: Suggested Citation