Instability of Return Prediction Models

43 Pages Posted: 31 May 2005

See all articles by Bradley S. Paye

Bradley S. Paye

Virginia Tech - Department of Finance, Insurance, and Business Law

Allan Timmermann

UCSD ; Centre for Economic Policy Research (CEPR)

Date Written: March 23, 2005


This study examines evidence of instability in models of ex post predictable components in stock returns related to structural breaks in the coefficients of state variables such as the lagged dividend yield, short interest rate, term spread and default premium. We estimate linear models of excess returns for a set of international equity indices and test for stability of the estimated regression parameters. There is evidence of instability for the vast majority of countries. We then attempt to characterize the timing and nature of the breaks. Breaks do not generally appear to be uniform in time: different countries experience breaks at different times. We do identify a contemporaneous break for the US and UK indices in 1974. There is also some evidence of a break for a cluster of European nations during the 1978-1982 period. These breaks may relate to the oil price shock of 1974 and the formation of the European Monetary System in 1979. For the majority of intenational indices, the predictable component in stock returns appears to have diminished following the most recent break. We assess the adequecy of the break tests and model selection procedures in a set of Monte Carlo experiments.

Keywords: Stock return predictability, model instability, structural breaks

JEL Classification: G10

Suggested Citation

Paye, Bradley S. and Timmermann, Allan, Instability of Return Prediction Models (March 23, 2005). Available at SSRN: or

Bradley S. Paye

Virginia Tech - Department of Finance, Insurance, and Business Law ( email )

1016 Pamplin Hall (0221)
Blacksburg, VA 24060-0221
United States

Allan Timmermann (Contact Author)

UCSD ( email )

9500 Gilman Drive
La Jolla, CA 92093-0553
United States
858-534-0894 (Phone)


Centre for Economic Policy Research (CEPR)

United Kingdom

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