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

57 Pages Posted: 23 Jan 2006

See all articles by Stijn Van Nieuwerburgh

Stijn Van Nieuwerburgh

Columbia University Graduate School of Business; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR); ABFER

Martin Lettau

University of California - Haas School of Business; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Multiple version iconThere are 4 versions of this paper

Date Written: November 2005

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 as well as 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 relationship 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 parameter instability and poor out-of-sample performance of unadjusted price ratios that is 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.

Keywords: Predictibility, Stock returns, dividend price ratio, price ratios, out-of-sample test

JEL Classification: C12, C22, G1

Suggested Citation

Van Nieuwerburgh, Stijn and Lettau, Martin, Reconciling the Return Predictability Evidence: In-Sample Forecasts, Out-of-Sample Forecasts, and Parameter Instability (November 2005). CEPR Discussion Paper No. 5355, Available at SSRN: https://ssrn.com/abstract=877950

Stijn Van Nieuwerburgh

Columbia University Graduate School of Business ( email )

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HOME PAGE: http://https://www0.gsb.columbia.edu/faculty/svannieuwerburgh/

National Bureau of Economic Research (NBER)

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Centre for Economic Policy Research (CEPR)

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ABFER ( email )

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Martin Lettau (Contact Author)

University of California - Haas School of Business ( email )

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HOME PAGE: http://faculty.haas.berkeley.edu/lettau/

Centre for Economic Policy Research (CEPR)

London
United Kingdom

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
United States

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