Simple Tests for Stock Return Predictability with Good Size and Power Properties

Harvey, David I; Leybourne, Stephen J; Taylor, A M Robert

Abstract

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 t-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 into the standard t-ratio test with reference to standard normal critical values.

Citation

Harvey, D. I., Leybourne, S. J., & Taylor, A. M. R. (2021). Simple Tests for Stock Return Predictability with Good Size and Power Properties. Journal of Econometrics, 224(1), 198-214. https://doi.org/10.1016/j.jeconom.2021.01.004

• Journal Article Type: Article
• Acceptance Date: Jan 31, 2021
• Online Publication Date: Feb 23, 2021
• Publication Date: 2021-09
• Deposit Date: Feb 3, 2021
• Publicly Available Date: Feb 24, 2023
• Journal: Journal of Econometrics
• Print ISSN: 0304-4076
• Electronic ISSN: 1872-6895
• Publisher: Elsevier
• Peer Reviewed: Peer Reviewed
• Volume: 224
• Issue: 1
• Pages: 198-214
• DOI: https://doi.org/10.1016/j.jeconom.2021.01.004
• Keywords: predictive regression; persistence; endogeneity; quasi-GLS demeaning; unit root test; hybrid statistic JEL classification: C12, C22
• Public URL: https://nottingham-repository.worktribe.com/output/5289900
• Publisher URL: https://www.sciencedirect.com/science/article/pii/S0304407621000270