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Efficient Tests of Stock Return Predictability

  • John Y. Campbell
  • Motohiro Yogo

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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Paper provided by Harvard - Institute of Economic Research in its series Harvard Institute of Economic Research Working Papers with number 1972.

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Date of creation: 2002
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Handle: RePEc:fth:harver:1972
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  1. Michael Jansson & Marcelo J. Moreira, 2004. "Optimal Inference in Regression Models with Nearly Integrated Regressors," Harvard Institute of Economic Research Working Papers 2047, Harvard - Institute of Economic Research.
  2. Dufour, J.M. & Campbell, B., 1993. "Exact Nonparametric Orthogonality and Random Walk Tests," Cahiers de recherche 9326, Centre interuniversitaire de recherche en économie quantitative, CIREQ.
  3. repec:cup:etheor:v:11:y:1995:i:5:p:1131-47 is not listed on IDEAS
  4. Lewellen, Jonathan, 2004. "Predicting returns with financial ratios," Journal of Financial Economics, Elsevier, vol. 74(2), pages 209-235, November.
  5. Gregory Mankiw, N. & Shapiro, Matthew D., 1986. "Do we reject too often? : Small sample properties of tests of rational expectations models," Economics Letters, Elsevier, vol. 20(2), pages 139-145.
  6. Elliott, Graham & Stock, James H., 2001. "Confidence intervals for autoregressive coefficients near one," Journal of Econometrics, Elsevier, vol. 103(1-2), pages 155-181, July.
  7. Graham Elliott & Thomas J. Rothenberg & James H. Stock, 1992. "Efficient Tests for an Autoregressive Unit Root," NBER Technical Working Papers 0130, National Bureau of Economic Research, Inc.
  8. Kothari, S. P. & Shanken, Jay, 1997. "Book-to-market, dividend yield, and expected market returns: A time-series analysis," Journal of Financial Economics, Elsevier, vol. 44(2), pages 169-203, May.
  9. Fama, Eugene F. & French, Kenneth R., 1989. "Business conditions and expected returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 25(1), pages 23-49, November.
  10. Campbell, John, 1987. "Stock Returns and the Term Structure," Scholarly Articles 3207699, Harvard University Department of Economics.
  11. 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.
  12. John H. Cochrane, 1999. "New facts in finance," Economic Perspectives, Federal Reserve Bank of Chicago, issue Q III, pages 36-58.
  13. James H. Stock, 1991. "Confidence Intervals for the Largest Autoresgressive Root in U.S. Macroeconomic Time Series," NBER Technical Working Papers 0105, National Bureau of Economic Research, Inc.
  14. Valkanov, Rossen, 2003. "Long-horizon regressions: theoretical results and applications," Journal of Financial Economics, Elsevier, vol. 68(2), pages 201-232, May.
  15. Amit Goyal & Ivo Welch, 2003. "Predicting the Equity Premium with Dividend Ratios," Management Science, INFORMS, vol. 49(5), pages 639-654, May.
  16. Fama, Eugene F. & French, Kenneth R., 1988. "Dividend yields and expected stock returns," Journal of Financial Economics, Elsevier, vol. 22(1), pages 3-25, October.
  17. Hodrick, Robert J, 1992. "Dividend Yields and Expected Stock Returns: Alternative Procedures for Inference and Measurement," Review of Financial Studies, Society for Financial Studies, vol. 5(3), pages 357-86.
  18. Andrew Ang & Geert Bekaert, 2001. "Stock Return Predictability: Is it There?," NBER Working Papers 8207, National Bureau of Economic Research, Inc.
  19. Donald B. Keim & Robert F. Stambaugh, . "Predicting Returns in the Stock and Bond Markets," Rodney L. White Center for Financial Research Working Papers 15-85, Wharton School Rodney L. White Center for Financial Research.
  20. Markku Lanne, 2002. "Testing The Predictability Of Stock Returns," The Review of Economics and Statistics, MIT Press, vol. 84(3), pages 407-415, August.
  21. Campbell, Bryan & Dufour, Jean-Marie, 1991. "Over-rejections in rational expectations models : A non-parametric approach to the Mankiw-Shapiro problem," Economics Letters, Elsevier, vol. 35(3), pages 285-290, March.
  22. Campbell, John Y., 2001. "Why long horizons? A study of power against persistent alternatives," Journal of Empirical Finance, Elsevier, vol. 8(5), pages 459-491, December.
  23. Graham Elliott & James H. Stock, 1992. "Inference in Time Series Regression When the Order of Integration of a Regressor is Unknown," NBER Technical Working Papers 0122, National Bureau of Economic Research, Inc.
  24. Nelson, Charles R & Kim, Myung J, 1993. " Predictable Stock Returns: The Role of Small Sample Bias," Journal of Finance, American Finance Association, vol. 48(2), pages 641-61, June.
  25. Evans, G B A & Savin, N E, 1981. "Testing for Unit Roots: 1," Econometrica, Econometric Society, vol. 49(3), pages 753-79, May.
  26. Campbell, John Y & Shiller, Robert J, 1988. " Stock Prices, Earnings, and Expected Dividends," Journal of Finance, American Finance Association, vol. 43(3), pages 661-76, July.
  27. Stambaugh, Robert F., 1999. "Predictive regressions," Journal of Financial Economics, Elsevier, vol. 54(3), pages 375-421, December.
  28. Fama, Eugene F. & Schwert, G. William, 1977. "Asset returns and inflation," Journal of Financial Economics, Elsevier, vol. 5(2), pages 115-146, November.
  29. repec:cup:etheor:v:10:y:1994:i:3-4:p:672-700 is not listed on IDEAS
  30. Christopher Polk & Samuel Thompson & Tuomo Vuolteenaho, 2004. "New Forecasts of the Equity Premium," NBER Working Papers 10406, National Bureau of Economic Research, Inc.
  31. Cavanagh, Christopher L. & Elliott, Graham & Stock, James H., 1995. "Inference in Models with Nearly Integrated Regressors," Econometric Theory, Cambridge University Press, vol. 11(05), pages 1131-1147, October.
  32. Richardson, Matthew & Stock, James H., 1989. "Drawing inferences from statistics based on multiyear asset returns," Journal of Financial Economics, Elsevier, vol. 25(2), pages 323-348, December.
  33. Frederick R. Macaulay, 1938. "Some Theoretical Problems Suggested by the Movements of Interest Rates, Bond Yields and Stock Prices in the United States since 1856," NBER Books, National Bureau of Economic Research, Inc, number maca38-1, December.
  34. Walter Torous & Rossen Valkanov & Shu Yan, 2004. "On Predicting Stock Returns with Nearly Integrated Explanatory Variables," The Journal of Business, University of Chicago Press, vol. 77(4), pages 937-966, October.
  35. Evans, G B A & Savin, N E, 1984. "Testing for Unit Roots: 2," Econometrica, Econometric Society, vol. 52(5), pages 1241-69, September.
  36. Dickey, David A & Fuller, Wayne A, 1981. "Likelihood Ratio Statistics for Autoregressive Time Series with a Unit Root," Econometrica, Econometric Society, vol. 49(4), pages 1057-72, June.
  37. Lewellen, Jonathan, 2003. "Predicting Returns With Financial Ratios," Working papers 4374-02, Massachusetts Institute of Technology (MIT), Sloan School of Management.
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