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Please use this identifier to cite or link to this item:
http://hdl.handle.net/2451/26621
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| Title: | RECONCILING THE RETURN PREDICTABILITY EVIDENCE IN-SAMPLE FORECASTS,
OUT-OF-SAMPLE FORECASTS, AND PARAMETER INSTABILITY |
| Authors: | Lettau, Martin
Nieuwerburgh, Stijn Van |
| Issue Date: | 1-Nov-2005 |
| Series/Report no.: | SC-AM-05-13 |
| 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, 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. |
| URI: | http://hdl.handle.net/2451/26621 |
| Appears in Collections: | Asset Management
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