Testing the Economic Value of Asset Return Predictability

Abstract

Economic value calculations are increasingly used to compare the predictive performance of competing models of asset returns. However, they lack a rigorous way to validate their evidence. This paper proposes a new methodology to test whether utility gains accruing to investors using competing predictive models are equal to zero. Monte Carlo evidence indicates that our testing procedure, that can account for estimation error in the asymptotic variance of the test statistic, provides accurately sized and powerful tests in empirically relevant sample sizes. We apply the test statistics proposed in the paper to revisit the predictability of the US equity premium by means of various predictors.

Keywords: Utility-based comparisons, economic value, out-of-sample forecasting, predictability

JEL Classification: C53, C12, C52