TY  - JOUR
AU  - Lettau,Martin
AU  - Nieuwerburgh,Stijn Van
TI  - Reconciling the Return Predictability Evidence
JF  - National Bureau of Economic Research Working Paper Series
VL  - No. 12109
PY  - 2006
Y2  - March 2006
UR  - http://www.nber.org/papers/w12109
L1  - http://www.nber.org/papers/w12109.pdf
N1  - Author contact info:
Martin Lettau
Haas School of Business
University of California, Berkeley
545 Student Services Bldg. #1900
Berkeley, CA 94720-1900
Tel: 510/642-6349
Fax: 510/643-1412
E-Mail: lettau@haas.berkeley.edu

Stijn Van Nieuwerburgh
Stern School of Business
New York University
44 W 4th Street, Suite 9-120
New York, NY 10012
Tel: 646/284-4141
Fax: 646/284-4141
E-Mail: svnieuwe@stern.nyu.edu
M2  - featured in NBER digest on 2006-03-20
AB  - 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.
ER  -