Working Paper: NBER ID: w12109
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 and by 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 adjusted price ratios and future returns is statistically significant and stable over time. We also show that shifts in the steady-state are responsible for the parameter instability and poor out-of-sample performance of unadjusted price ratios that are 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: No keywords provided
JEL Codes: G1; G12; G11; C53
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| shifts in the steady-state mean of financial ratios (G32) | changes in the forecasting relationship between these ratios and future returns (G17) |
| nonstationary price ratios (P22) | complications in the forecasting relationship (C53) |
| adjusted price ratios (P22) | stable forecasting relationships with future returns (G17) |
| unadjusted price ratios (P22) | poor out-of-sample forecasting power (C53) |
| structural breaks in the data (C22) | misinterpretations of predictability (D80) |
| adjustments for shifts in the steady-state mean (C22) | enhanced predictability of returns (G17) |