Working Paper: CEPR ID: DP5355
Authors: Martin Lettau; Stijn Van Nieuwerburgh
Abstract: Evidence of stock return predictability by financial ratios is still controversial as documented by inconsistent results for in-sample and out-of-sample regressions as well as substantial parameter instability. This paper shows that these seemingly incompatible results can be reconciled if the assumption of a fixed steady state mean of the economy is relaxed. We find strong empirical evidence in support of shifts in the steady state and propose simple methods to adjust financial ratios for such shifts. The forecasting relationship of adjustedprice ratios and future returns is statistically significant, stable over time and present in out-of-sample tests. We also show that shifts in the steady state are responsible for parameter instability and poor out-of-sample performance of unadjusted price ratios that is found in the data. Our conclusions hold for a variety of financial ratios and are robust to changes in the econometric technique used to estimate shifts in the steady state.
Keywords: Price Ratios; Dividend Price Ratio; Out-of-Sample Test; Predictability; Stock Returns
JEL Codes: C12; C22; G1
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| adjusted dividend-price ratio (G35) | future stock returns (G17) |
| shifts in the steady-state mean of financial ratios (G32) | parameter instability of unadjusted ratios (C22) |
| shifts in the steady-state mean of financial ratios (G32) | poor out-of-sample performance of unadjusted ratios (C52) |
| adjusting for structural breaks (C22) | enhanced predictive accuracy of stock returns (G17) |