Reconciling the Return Predictability Evidence / Martin Lettau, Stijn Van Nieuwerburgh.

Format:

Book

Author/Creator:

Lettau, Martin.

Contributor:

National Bureau of Economic Research.

Van Nieuwerburgh, Stijn.

Series:

Working Paper Series (National Bureau of Economic Research) no. w12109.

NBER working paper series no. w12109

Language:

English

Physical Description:

1 online resource: illustrations (black and white);

Place of Publication:

Cambridge, Mass. National Bureau of Economic Research 2006.

Summary:

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.

Notes:

Print version record

March 2006.