Working Paper: NBER ID: w10026
Authors: John Y. Campbell; Motohiro Yogo
Abstract: 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.
Keywords: stock returns; predictability; financial variables; t-tests; Bonferroni test
JEL Codes: C22; G1
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| conventional t-tests are invalid for the dividend-price and smoothed earnings-price ratios (C12) | over-rejection of the null hypothesis (C52) |
| persistence of predictor variables and correlation of their innovations with returns (C22) | invalid conclusions from conventional t-tests (C12) |
| innovations in earnings-price ratio (O49) | predictability of stock returns (G17) |
| dividend-price ratio (G35) | predict returns at an annual frequency (G17) |
| short-term nominal interest rate (E43) | predict returns (G17) |
| long-short yield spread (E43) | predict returns (G17) |