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Efficient tests of stock return predictability

  • Campbell, John
  • Yogo, Motohiro

Conventional tests of the predictability of stock returns could be invalid, that is reject the null too frequently, when the predictor variable is persistent and its innovations are highly correlated with returns. We develop a pretest to determine whether the conventional t-test leads to invalid inference and an efficient test of predictability that corrects this problem. Although the conventional t-test is invalid for the dividend–price and smoothed earnings–price ratios, our test finds evidence for predictability. We also find evidence for predictability with the short rate and the long-short yield spread, for which the conventional t-test leads to valid inference.

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File URL: http://dash.harvard.edu/bitstream/handle/1/3122601/campbellssrn_stockreturn.pdf
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Paper provided by Harvard University Department of Economics in its series Scholarly Articles with number 3122601.

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Date of creation: 2006
Date of revision:
Publication status: Published in Journal of Financial Economics
Handle: RePEc:hrv:faseco:3122601
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Web page: http://www.economics.harvard.edu/

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  1. Amit Goyal & Ivo Welch, 2002. "Predicting the Equity Premium With Dividend Ratios," NBER Working Papers 8788, National Bureau of Economic Research, Inc.
  2. John H. Cochrane, 1999. "New facts in finance," Economic Perspectives, Federal Reserve Bank of Chicago, issue Q III, pages 36-58.
  3. 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.
  4. 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.
  5. John Y. Campbell & Robert J. Shiller, 1988. "Stock Prices, Earnings and Expected Dividends," NBER Working Papers 2511, National Bureau of Economic Research, Inc.
  6. Campbell, John, 2001. "Why Long Horizons? A Study of Power Against Persistent Alternatives," Scholarly Articles 3196341, Harvard University Department of Economics.
  7. 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.
  8. Campbell, John, 1987. "Stock Returns and the Term Structure," Scholarly Articles 3207699, Harvard University Department of Economics.
  9. repec:cup:etheor:v:11:y:1995:i:5:p:1131-47 is not listed on IDEAS
  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. Lewellen, Jonathan, 2003. "Predicting Returns With Financial Ratios," Working papers 4374-02, Massachusetts Institute of Technology (MIT), Sloan School of Management.
  12. 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.
  13. 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.
  14. 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.
  15. 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.
  16. 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.
  17. 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.
  18. 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.
  19. Stambaugh, Robert F., 1999. "Predictive regressions," Journal of Financial Economics, Elsevier, vol. 54(3), pages 375-421, December.
  20. 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.
  21. 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.
  22. Campbell, John & Yogo, Motohiro, 2006. "Efficient tests of stock return predictability," Scholarly Articles 3122601, Harvard University Department of Economics.
  23. repec:cup:etheor:v:10:y:1994:i:3-4:p:672-700 is not listed on IDEAS
  24. 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.
  25. 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.
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  27. Markku Lanne, 2002. "Testing The Predictability Of Stock Returns," The Review of Economics and Statistics, MIT Press, vol. 84(3), pages 407-415, August.
  28. Campbell, Bryan & Dufour, Jean-Marie, 1995. "Exact Nonparametric Orthogonality and Random Walk Tests," The Review of Economics and Statistics, MIT Press, vol. 77(1), pages 1-16, February.
  29. Andrew Ang & Geert Bekaert, 2001. "Stock Return Predictability: Is it There?," NBER Working Papers 8207, National Bureau of Economic Research, Inc.
  30. Evans, G B A & Savin, N E, 1984. "Testing for Unit Roots: 2," Econometrica, Econometric Society, vol. 52(5), pages 1241-69, September.
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  32. Valkanov, Rossen, 2003. "Long-horizon regressions: theoretical results and applications," Journal of Financial Economics, Elsevier, vol. 68(2), pages 201-232, May.
  33. 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.
  34. 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, May.
  35. 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.
  36. 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.
  37. Lewellen, Jonathan, 2004. "Predicting returns with financial ratios," Journal of Financial Economics, Elsevier, vol. 74(2), pages 209-235, November.
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