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

55 Pages Posted: 8 Apr 2006  

Stijn Van Nieuwerburgh

New York University Stern School of Business, Department of Finance; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Martin Lettau

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

Date Written: December 13, 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 and by 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 relationships 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 the parameter instability and poor out-of sample performance of unadjusted price ratios that are 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.

Suggested Citation

Van Nieuwerburgh, Stijn and Lettau, Martin, Reconciling the Return Predictability Evidence In-Sample Forecasts, Out-of-Sample Forecasts, and Parameter Instability* (December 13, 2005). 8th Annual Texas Finance Festival . Available at SSRN: https://ssrn.com/abstract=895842 or http://dx.doi.org/10.2139/ssrn.895842

Stijn Van Nieuwerburgh

New York University Stern School of Business, Department of Finance ( email )

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New York, NY 10012-1126
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National Bureau of Economic Research (NBER)

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Centre for Economic Policy Research (CEPR)

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London, EC1V 3PZ
United Kingdom

Martin Lettau (Contact Author)

University of California - Haas School of Business ( email )

Haas School of Business
545 Student Services Building
Berkeley, CA 94720
United States
5106436349 (Phone)

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

Centre for Economic Policy Research (CEPR)

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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