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Efficient Tests of Stock Return Predictability

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  • John Y. Campbell
  • Motohiro Yogo

Abstract

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.

Suggested Citation

  • John Y. Campbell & Motohiro Yogo, 2002. "Efficient Tests of Stock Return Predictability," Harvard Institute of Economic Research Working Papers 1972, Harvard - Institute of Economic Research.
  • Handle: RePEc:fth:harver:1972
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    References listed on IDEAS

    as
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    JEL classification:

    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • G1 - Financial Economics - - General Financial Markets

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