Title: | Reconciling the Return Predictability Evidence |
Authors: | Lettau, Martin Van Nieuwerburgh, Stijn |
Issue Date: | 27-Apr-2006 |
Series/Report no.: | FIN-06-013 |
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 in-sample forecasting relationship of adjusted price ratios and future returns is statistically significant and stable over time. In real-time,however, changes in the steady-state make the in-sample return forecast ability hard to exploit out-of-sample. The uncertainty of estimating the size of steady-state shifts rather than the estimation of their dates is responsible for the difficulty of forecasting stock returns in real-time. 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/2451/26374 |
Appears in Collections: | Finance Working Papers |
Files in This Item:
File | Description | Size | Format | |
---|---|---|---|---|
FIN-06-013.pdf | 385.72 kB | Adobe PDF | View/Open |
Items in FDA are protected by copyright, with all rights reserved, unless otherwise indicated.