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RFS Advance Access originally published online on December 10, 2007
Review of Financial Studies 2008 21(4):1607-1652; doi:10.1093/rfs/hhm074
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© The Author 2007. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org

Reconciling the Return Predictability Evidence

Martin Lettau
Columbia University, New York University, CEPR, NBER

Stijn Van Nieuwerburgh
New York University and NBER

Address correspondence to M. Lettau, Department of Economics, Columbia University, International Affairs Building, 420 W. 118th Street, New York 10027; telephone: (212) 998-0378; or e-mail: mlettau{at}columbia.edu.

JEL Classification: 12, 14


  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 article 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 in-sample forecasting relationship of adjusted price ratios and future returns is statistically significant and stable over time. In real time, however, changes in the steady state make the in-sample return forecastability hard to exploit out-of-sample. The uncertainty of estimating the size of steady-state shifts rather than the estimation of their dates is responsible for the difficulty of forecasting stock returns in real time. 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.

We thank an anonymous referee, Matt Spiegel (the editor), Yakov Amihud, John Campbell, Kenneth French, Sydney Ludvigson, Eli Ofek, Matthew Richardson, Ivo Welch, Robert Whitelaw, and the seminar participants at Duke, McGill, NYU, UNC, and Wharton for comments.


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