TY - JOUR
AU - Nelson,Charles R.
AU - Kim,Myung J.
TI - Predictable Stock Returns: Reality or Statistical Illusion?
JF - National Bureau of Economic Research Working Paper Series
VL - No. 3297
PY - 1990
Y2 - March 1990
DO - 10.3386/w3297
UR - http://www.nber.org/papers/w3297
L1 - http://www.nber.org/papers/w3297.pdf
N1 - Author contact info:
Charles Nelson
Department of Economics
University of Washington
Seattle, WA 93195
E-Mail: cnelson@u.washington.edu
AB - Recent research suggests that stock returns are predictable from fundamentals such as dividend yield, and that the degree of predictability rises with the length of the horizon over which return is measured. This paper investigates the magnitude of two sources of small simple bias in these results. First, it is a standard result in econometrics that regression on the lagged value of the dependent variable is biased in finite samples. Since a fundamental such as the price/dividend ratio is a statistical proxy for lagged price, predictive regressions are potentially subject to a corresponding small sample bias. This may create the illusion that one can buy low and sell high in the sample even if the relationship is useless for forecasting. Second, multiperiod returns are positively autocorrelated by construction, raising the possibility of spurious regression. Standard errors which are computed from the asymptotic formula may not be large enough in small samples. A set of Monte Carlo experiments are presented in which data are generated by a version of the present value model in which the discount rate is constant so returns are not in fact predictable. We show that a number of the characteristica of the historical results can be replicated simply by the combined effects of the two small sample biases.
ER -