Advanced Search
MyIDEAS: Login to save this paper or follow this series

Reconciling the Return Predictability Evidence

Contents:

Author Info

  • Martin Lettau
  • Stijn Van Nieuwerburgh

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 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.

Download Info

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
File URL: http://www.nber.org/papers/w12109.pdf
Download Restriction: no

Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 12109.

as in new window
Length:
Date of creation: Mar 2006
Date of revision:
Publication status: published as Martin Lettau & Stijn Van Nieuwerburgh, 2008. "Reconciling the Return Predictability Evidence," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 21(4), pages 1607-1652, July.
Handle: RePEc:nbr:nberwo:12109

Note: AP
Contact details of provider:
Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.
Phone: 617-868-3900
Email:
Web page: http://www.nber.org
More information through EDIRC

Related research

Keywords:

Other versions of this item:

Find related papers by JEL classification:

This paper has been announced in the following NEP Reports:

References

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
as in new window
  1. John Y. Campbell & Samuel B. Thompson, 2005. "Predicting the Equity Premium Out of Sample: Can Anything Beat the Historical Average?," NBER Working Papers 11468, National Bureau of Economic Research, Inc.
  2. Llubos Pástor, 2001. "The Equity Premium and Structural Breaks," Journal of Finance, American Finance Association, American Finance Association, vol. 56(4), pages 1207-1239, 08.
  3. Owen Lamont, 1998. "Earnings and Expected Returns," Journal of Finance, American Finance Association, American Finance Association, vol. 53(5), pages 1563-1587, October.
  4. John Y. Campbell, 1990. "A Variance Decomposition for Stock Returns," NBER Working Papers 3246, National Bureau of Economic Research, Inc.
  5. Fatih Guvenen, 2005. "A Parsimonious Macroeconomic Model for Asset Pricing: Habit Formation of Cross-sectional Heterogeneity?," Finance, EconWPA 0507009, EconWPA.
  6. Amit Goyal & Ivo Welch, 2003. "Predicting the Equity Premium with Dividend Ratios," Management Science, INFORMS, INFORMS, vol. 49(5), pages 639-654, May.
  7. Andrew Ang & Geert Bekaert, 2001. "Stock Return Predictability: Is it There?," NBER Working Papers 8207, National Bureau of Economic Research, Inc.
  8. Laurent Calvet & Martin Gonzalez-Eiras & Paolo Sodini, 2003. "Financial Innovation, Market Participation and Asset Prices," NBER Working Papers 9840, National Bureau of Economic Research, Inc.
  9. Jacob Boudoukh & Roni Michaely & Matthew Richardson & Michael R. Roberts, 2007. "On the Importance of Measuring Payout Yield: Implications for Empirical Asset Pricing," Journal of Finance, American Finance Association, American Finance Association, vol. 62(2), pages 877-915, 04.
  10. Nelson, Charles R & Kim, Myung J, 1993. " Predictable Stock Returns: The Role of Small Sample Bias," Journal of Finance, American Finance Association, American Finance Association, vol. 48(2), pages 641-61, June.
  11. Fama, Eugene F. & French, Kenneth R., 2001. "Disappearing dividends: changing firm characteristics or lower propensity to pay?," Journal of Financial Economics, Elsevier, Elsevier, vol. 60(1), pages 3-43, April.
  12. John Y. Campbell & Motohiro Yogo, 2003. "Efficient Tests of Stock Return Predictability," NBER Working Papers 10026, National Bureau of Economic Research, Inc.
  13. Ellen R. McGrattan & Edward C. Prescott, 2004. "Taxes, Regulations, and the Value of U.S. and U.K. Corporations," Levine's Bibliography 122247000000000715, UCLA Department of Economics.
  14. Martin Lettau & Sydney C. Ludvigson & Jessica A. Wachter, 2008. "The Declining Equity Premium: What Role Does Macroeconomic Risk Play?," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 21(4), pages 1653-1687, July.
  15. Walter Torous & Rossen Valkanov & Shu Yan, 2004. "On Predicting Stock Returns with Nearly Integrated Explanatory Variables," The Journal of Business, University of Chicago Press, University of Chicago Press, vol. 77(4), pages 937-966, October.
  16. Martin Lettau & Sydney Ludvigson, 2003. "Expected Returns and Expected Dividend Growth," NBER Working Papers 9605, National Bureau of Economic Research, Inc.
  17. Yakov Amihud & Clifford Hurvich & Yi Wang, 2004. "Hypothesis Testing in Predictive Regressions," Finance, EconWPA 0412022, EconWPA.
  18. Annette Vissing-Jorgensen, 2002. "Limited Asset Market Participation and the Elasticity of Intertemporal Substitution," NBER Working Papers 8896, National Bureau of Economic Research, Inc.
  19. Lior Menzly & Tano Santos & Pietro Veronesi, 2004. "Understanding Predictability," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 112(1), pages 1-47, February.
  20. Hanno Lustig & Stijn Van Nieuwerburgh, 2003. "Housing Collateral, Consumption Insurance and Risk Premia: An Empirical Perpective," NBER Working Papers 9959, National Bureau of Economic Research, Inc.
  21. Yakov Amihud & Clifford Hurvich, 2004. "Predictive Regressions: A Reduced-Bias Estimation Method," Econometrics, EconWPA 0412008, EconWPA.
  22. Goetzman, W.N. & Jorion, P., 1992. "Testing the Predictive Power of Dividend Yields," Papers, Columbia - Graduate School of Business 93-03, Columbia - Graduate School of Business.
  23. Amit Goyal & Ivo Welch, 2004. "A Comprehensive Look at the Empirical Performance of Equity Premium Prediction," Yale School of Management Working Papers, Yale School of Management amz2412, Yale School of Management, revised 01 Jan 2006.
  24. Hanno Lustig & Stijn Van Nieuwerburgh, 2004. "How Much Does Household Collateral Constrain Regional Risk Sharing?," NBER Working Papers 10505, National Bureau of Economic Research, Inc.
  25. John H. Cochrane, 2006. "The Dog That Did Not Bark: A Defense of Return Predictability," NBER Working Papers 12026, National Bureau of Economic Research, Inc.
  26. Wayne E. Ferson & Sergei Sarkissian & Timothy T. Simin, 2003. "Spurious Regressions in Financial Economics?," Journal of Finance, American Finance Association, American Finance Association, vol. 58(4), pages 1393-1414, 08.
  27. Matthew D. Shapiro & N. Gregory Mankiw, 1985. "Risk and Return: Consumption Beta Versus Market Beta," Cowles Foundation Discussion Papers, Cowles Foundation for Research in Economics, Yale University 738, Cowles Foundation for Research in Economics, Yale University.
  28. Jacob Boudoukh & Matthew Richardson & Robert Whitelaw, 2005. "The Myth of Long-Horizon Predictability," NBER Working Papers 11841, National Bureau of Economic Research, Inc.
  29. Annette Vissing-Jorgensen, 2002. "Limited Asset Market Participation and the Elasticity of Intertemporal Substitution," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 110(4), pages 825-853, August.
  30. Lewellen, Jonathan, 2004. "Predicting returns with financial ratios," Journal of Financial Economics, Elsevier, Elsevier, vol. 74(2), pages 209-235, November.
  31. Valkanov, Rossen, 2003. "Long-horizon regressions: theoretical results and applications," Journal of Financial Economics, Elsevier, Elsevier, vol. 68(2), pages 201-232, May.
  32. Bossaerts, Peter & Hillion, Pierre, 1999. "Implementing Statistical Criteria to Select Return Forecasting Models: What Do We Learn?," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 12(2), pages 405-28.
  33. Fama, Eugene F. & French, Kenneth R., 1988. "Dividend yields and expected stock returns," Journal of Financial Economics, Elsevier, Elsevier, vol. 22(1), pages 3-25, October.
  34. Hodrick, Robert J, 1992. "Dividend Yields and Expected Stock Returns: Alternative Procedures for Inference and Measurement," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 5(3), pages 357-86.
  35. Hansen, Lars Peter & Hodrick, Robert J, 1980. "Forward Exchange Rates as Optimal Predictors of Future Spot Rates: An Econometric Analysis," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 88(5), pages 829-53, October.
Full references (including those not matched with items on IDEAS)

Citations

Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
as in new window

Cited by:
This item has more than 25 citations. To prevent cluttering this page, these citations are listed on a separate page.

Lists

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

Statistics

Access and download statistics

Corrections

When requesting a correction, please mention this item's handle: RePEc:nbr:nberwo:12109. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: ().

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.