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Efficient tests of stock return predictability

Listed author(s):
  • Campbell, John Y.
  • Yogo, Motohiro

Empirical studies have suggested that stock returns can be predicted by ï¬ nancial variables such as the dividend-price ratio. However, these studies typically ignore the high persistence of predictor variables, which can make ï¬ rst-order asymptotics a poor approximation in ï¬ nite samples. Using a more accurate asymptotic approximation, we propose two methods to deal with the persistence problem. First, we develop a pretest that determines when the conventional t-test for predictability is misleading. Second, we develop a new test of predictability that results in correct inference regardless of the degree of persistence and is efficient compared to existing methods. Applying our methods to US data, we ï¬ nd that the dividend-price ratio and the smoothed earningsprice ratio are sufficiently persistent for conventional inference to be highly misleading. However, we ï¬ nd some evidence for predictability using our test, particularly with the earnings-price ratio. We also ï¬ nd evidence for predictability with the short-term interest rate and the long-short yield spread, for which the conventional t-test leads to correct inference.

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Article provided by Elsevier in its journal Journal of Financial Economics.

Volume (Year): 81 (2006)
Issue (Month): 1 (July)
Pages: 27-60

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Handle: RePEc:eee:jfinec:v:81:y:2006:i:1:p:27-60
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/505576

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