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Efficient tests of stock return predictability

  • 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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  1. Fama, Eugene F. & Schwert, G. William, 1977. "Asset returns and inflation," Journal of Financial Economics, Elsevier, vol. 5(2), pages 115-146, November.
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  3. Campbell, B. & Dufour, J.-M., 1991. "Over-Rejections in Rational Expectations Models: A Nonparametric Approach to the Mankiw-Shapiro Problem," Cahiers de recherche 9116, Centre interuniversitaire de recherche en économie quantitative, CIREQ.
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