Reconciling the Return Predictability Evidenc: In-Sample Forecasts, Out-of-Sample Forecasts, and Parameter Instability

Evidence of stock return predictability by financial ratios is still controversial as documented by inconsistent results for in-sample and out-of-sample regressions as well as 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 parameter instability and poor out-of-sample performance of unadjusted price ratios that is 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.