Simple Tests for Stock Return Predictability with Good Size and Power Properties

David Harvey, Stephen J Leybourne and AM Robert Taylor

Essex Finance Centre Working Papers from University of Essex, Essex Business School

Abstract: We develop easy-to-implement tests for return predictability which, relative to extant tests in the literature, display attractive finite sample size control and power across a wide range of persistence and endogeneity levels for the predictor. Our approach is based on the standard regression t-ratio and a variant where the predictor is quasi-GLS (rather than OLS) demeaned. In the strongly persistent near-unit root environment, the limiting null distributions of these statistics depend on the endogeneity and local-to-unity parameters characterising the predictor. Analysis of the asymptotic local power functions of feasible implementations of these two tests, based on asymptotically conservative critical values, motivates a switching procedure between the two, employing the quasi-GLS demeaned variant unless the magnitude of the estimated endogeneity correlation parameter is small. Additionally, if the data suggests the predictor is weakly persistent, our approach switches into the standard t-ratio test with reference to standard normal critical values.

Keywords: predictive regression; persistence; endogeneity; quasi-GLS demeaning; unit root test; hybrid statistic (search for similar items in EconPapers)
Date: 2021-02-15
New Economics Papers: this item is included in nep-ecm, nep-ets and nep-ore
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Citations: View citations in EconPapers (4)

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Journal Article: Simple tests for stock return predictability with good size and power properties (2021)
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Persistent link: https://EconPapers.repec.org/RePEc:esy:uefcwp:29814

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