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Simple tests for stock return predictability with good size and power properties

Harvey, David I and Leybourne, Stephen J and Taylor, AM Robert (2021) 'Simple tests for stock return predictability with good size and power properties.' Journal of Econometrics. ISSN 0304-4076

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We develop easy-to-implement tests for return predictability which, relative to extant tests in the literature, display attractive finite sample size control and power across a wide range of persistence and endogeneity levels for the predictor. Our approach is based on the standard regression -ratio and a variant where the predictor is quasi-GLS (rather than OLS) demeaned. In the strongly persistent near-unit root environment, the limiting null distributions of these statistics depend on the endogeneity and local-to-unity parameters characterising the predictor. Analysis of the asymptotic local power functions of feasible implementations of these two tests, based on asymptotically conservative critical values, motivates a switching procedure between the two, employing the quasi-GLS demeaned variant unless the magnitude of the estimated endogeneity correlation parameter is small. Additionally, if the data suggests the predictor is weakly persistent, our approach switches to the standard -ratio test with reference to standard normal critical values.

Item Type: Article
Uncontrolled Keywords: Predictive regression, Persistence, Endogeneity, Quasi-GLS demeaning, Unit root test, Hybrid statistic
Divisions: Faculty of Social Sciences > Essex Business School
Faculty of Social Sciences > Essex Business School > Essex Finance Centre
Depositing User: Elements
Date Deposited: 19 Mar 2021 14:27
Last Modified: 19 Mar 2021 14:27

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