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A simple approach for diagnosing instabilities in predictive regressions

Listed author(s):
  • Pitarakis, Jean-Yves

We introduce a method for detecting the presence of time variation and instabilities in the parameters of predictive regressions linking noisy variables such as stock returns to highly persistent predictors such as stock market valuation ratios. Our proposed approach relies on the least squares based squared residuals of the predictive regression and is trivial to implement. More importantly the distribution of our test statistic is shown to be free of nuisance parameters, is already tabulated in the literature and is robust to the degree of persistence of the chosen predictor. Our proposed method is subsequently applied to the predictability of monthly US stock returns with the dividend yield, dividend payout, earnings-price, dividend-price and book-to-market value ratios. Our results strongly support the presence of instabilities over the 1927-2013 period but also clearly point to the disappearance of these after the mid 50s. Keywords; predictability of stock returns, structural breaks, CUSUMSQ, predictive regressions

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File URL: https://eprints.soton.ac.uk/374118/1/DP1519%2520Pitarakis.pdf
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Paper provided by Economics Division, School of Social Sciences, University of Southampton in its series Discussion Paper Series In Economics And Econometrics with number 1519.

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Date of creation: 01 Jan 2015
Handle: RePEc:stn:sotoec:1519
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  1. Ploberger, Werner & Krämer;, Walter, 1990. "The Local Power of the CUSUM and CUSUM of Squares Tests," Econometric Theory, Cambridge University Press, vol. 6(03), pages 335-347, September.
  2. Martin Lettau & Stijn Van Nieuwerburgh, 2008. "Reconciling the Return Predictability Evidence," Review of Financial Studies, Society for Financial Studies, vol. 21(4), pages 1607-1652, July.
  3. Ivo Welch & Amit Goyal, 2008. "A Comprehensive Look at The Empirical Performance of Equity Premium Prediction," Review of Financial Studies, Society for Financial Studies, vol. 21(4), pages 1455-1508, July.
  4. Michael Jansson & Marcelo J. Moreira, 2006. "Optimal Inference in Regression Models with Nearly Integrated Regressors," Econometrica, Econometric Society, vol. 74(3), pages 681-714, 05.
  5. Deng, Ai & Perron, Pierre, 2008. "A non-local perspective on the power properties of the CUSUM and CUSUM of squares tests for structural change," Journal of Econometrics, Elsevier, vol. 142(1), pages 212-240, January.
  6. David E. Rapach & Mark E. Wohar, 2006. "Structural Breaks and Predictive Regression Models of Aggregate U.S. Stock Returns," Journal of Financial Econometrics, Society for Financial Econometrics, vol. 4(2), pages 238-274.
  7. Sandberg, Rickard, 2009. "Convergence To Stochastic Power Integrals For Dependent Heterogeneous Processes," Econometric Theory, Cambridge University Press, vol. 25(03), pages 739-747, June.
  8. Jean-Yves Pitarakis, 2004. "Least squares estimation and tests of breaks in mean and variance under misspecification," Econometrics Journal, Royal Economic Society, vol. 7(1), pages 32-54, 06.
  9. Deng, Ai & Perron, Pierre, 2008. "The Limit Distribution Of The Cusum Of Squares Test Under General Mixing Conditions," Econometric Theory, Cambridge University Press, vol. 24(03), pages 809-822, June.
  10. Campbell, John Y. & Yogo, Motohiro, 2006. "Efficient tests of stock return predictability," Journal of Financial Economics, Elsevier, vol. 81(1), pages 27-60, July.
  11. Andrews, Donald W K, 1993. "Tests for Parameter Instability and Structural Change with Unknown Change Point," Econometrica, Econometric Society, vol. 61(4), pages 821-856, July.
  12. Timmermann, Allan, 2008. "Reply to the discussion of Elusive Return Predictability," International Journal of Forecasting, Elsevier, vol. 24(1), pages 29-30.
  13. Alexandros Kostakis & Tassos Magdalinos & Michalis P. Stamatogiannis, 2015. "Robust Econometric Inference for Stock Return Predictability," Review of Financial Studies, Society for Financial Studies, vol. 28(5), pages 1506-1553.
  14. Lewellen, Jonathan, 2004. "Predicting returns with financial ratios," Journal of Financial Economics, Elsevier, vol. 74(2), pages 209-235, November.
  15. Timmermann, Allan, 2008. "Elusive return predictability," International Journal of Forecasting, Elsevier, vol. 24(1), pages 1-18.
  16. Valkanov, Rossen, 2003. "Long-horizon regressions: theoretical results and applications," Journal of Financial Economics, Elsevier, vol. 68(2), pages 201-232, May.
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