Reconciling the Return Predictability Evidence In-sample Forecasts, Out-of-sample Forecasts, and Parameter Instability

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, stable over time, and present in out-of-sample tests. 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. ∗Lettau: Department of Finance, Stern School of Business, New York University, 44 W. 4th Street, New York, NY 10012; [email protected]; Tel: (212) 998-0378; http://www.stern.nyu.edu/ ̃mlettau. Van Nieuwerburgh: Department of Finance, Stern School of Business, New York University, 44 W. 4th Street, New York, NY 10012; [email protected]; Tel: (212) 998-0673; http://www.stern.nyu.edu/ ̃svnieuwe. We thank Yakov Amihud, John Campbell, Sydney Ludvigson, Eli Ofek, Matthew Richardson, Robert Whitelaw and the seminar participants at NYU and McGill University for comments.