Reconciling the Return Predictability Evidence

Martin Lettau () and Stijn Van Nieuwerburgh

No 12109, NBER Working Papers from National Bureau of Economic Research, Inc

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 relationship of adjusted price ratios and future returns is statistically significant and stable over time. 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.

JEL-codes: G1 G12 G11 C53 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-ets, nep-fin, nep-for and nep-rmg
Date: 2006-03
Note: AP
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Related works:
Working Paper: Reconciling the Return Predictability Evidence (2006)
Journal Article: Reconciling the Return Predictability Evidence (2008)
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