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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. 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.
  2. repec:cup:etheor:v:10:y:1994:i:3-4:p:672-700 is not listed on IDEAS
  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, Universite de Montreal, Departement de sciences economiques.
  4. Campbell, John, 1987. "Stock Returns and the Term Structure," Scholarly Articles 3207699, Harvard University Department of Economics.
  5. 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.
  6. Robert F. Stambaugh, 1999. "Predictive Regressions," NBER Technical Working Papers 0240, National Bureau of Economic Research, Inc.
  7. Evans, G B A & Savin, N E, 1984. "Testing for Unit Roots: 2," Econometrica, Econometric Society, vol. 52(5), pages 1241-69, September.
  8. Keim, Donald B. & Stambaugh, Robert F., 1986. "Predicting returns in the stock and bond markets," Journal of Financial Economics, Elsevier, vol. 17(2), pages 357-390, December.
  9. Evans, G B A & Savin, N E, 1981. "Testing for Unit Roots: 1," Econometrica, Econometric Society, vol. 49(3), pages 753-79, May.
  10. Christopher Polk & Samuel Thompson & Tuomo Vuolteenaho, 2004. "New Forecasts of the Equity Premium," NBER Working Papers 10406, National Bureau of Economic Research, Inc.
  11. John Y. Campbell, 1993. "Why Long Horizons: A Study of Power Against Persistent Alternatives," NBER Technical Working Papers 0142, National Bureau of Economic Research, Inc.
  12. Lanne, M., 2000. "Testing the Predictability of Stock Returns," University of Helsinki, Department of Economics 488, Department of Economics.
  13. John Y. Campbell & Motohiro Yogo, 2003. "Efficient Tests of Stock Return Predictability," NBER Working Papers 10026, National Bureau of Economic Research, Inc.
  14. N. Gregory Mankiw & Matthew D. Shapiro, 1985. "Do We Reject Too Often? Small Sample Properties of Tests of Rational Expectations Models," NBER Technical Working Papers 0051, National Bureau of Economic Research, Inc.
  15. Michael Jansson & Marcelo J. Moreira, 2004. "Optimal Inference in Regression Models with Nearly Integrated Regressors," NBER Technical Working Papers 0303, National Bureau of Economic Research, Inc.
  16. John H. Cochrane, 1999. "New Facts in Finance," NBER Working Papers 7169, National Bureau of Economic Research, Inc.
  17. 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.
  18. Amit Goyal & Ivo Welch, 2002. "Predicting the Equity Premium With Dividend Ratios," NBER Working Papers 8788, National Bureau of Economic Research, Inc.
  19. Campbell, John & Shiller, Robert, 1988. "Stock Prices, Earnings, and Expected Dividends," Scholarly Articles 3224293, Harvard University Department of Economics.
  20. Andrew Ang & Geert Bekaert, 2001. "Stock Return Predictability: Is it There?," NBER Working Papers 8207, National Bureau of Economic Research, Inc.
  21. Valkanov, Rossen, 2003. "Long-horizon regressions: theoretical results and applications," Journal of Financial Economics, Elsevier, vol. 68(2), pages 201-232, May.
  22. 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.
  23. Lewellen, Jonathan, 2003. "Predicting Returns With Financial Ratios," Working papers 4374-02, Massachusetts Institute of Technology (MIT), Sloan School of Management.
  24. 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.
  25. 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.
  26. Lewellen, Jonathan, 2004. "Predicting returns with financial ratios," Journal of Financial Economics, Elsevier, vol. 74(2), pages 209-235, November.
  27. 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, January.
  28. Elliott, Graham & Rothenberg, Thomas J & Stock, James H, 1996. "Efficient Tests for an Autoregressive Unit Root," Econometrica, Econometric Society, vol. 64(4), pages 813-36, July.
  29. Fama, Eugene F. & Schwert, G. William, 1977. "Asset returns and inflation," Journal of Financial Economics, Elsevier, vol. 5(2), pages 115-146, November.
  30. Stock, James H., 1991. "Confidence intervals for the largest autoregressive root in U.S. macroeconomic time series," Journal of Monetary Economics, Elsevier, vol. 28(3), pages 435-459, December.
  31. 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.
  32. 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.
  33. 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.
  34. 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.
  35. repec:cup:etheor:v:11:y:1995:i:5:p:1131-47 is not listed on IDEAS
  36. 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.
  37. 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.
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