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Maximal predictability under long-term mean reversion

Journal article
Authors Erik Hjalmarsson
Published in Journal of Empirical Finance
Volume 45
Issue January 2018
Pages 269-282
ISSN 0927-5398
Publication year 2018
Published at Department of Economics
Pages 269-282
Language en
Links https://doi.org/10.1016/j.jempfin.2...
Keywords Return predictability, Variance ratios
Subject categories Business Administration

Abstract

I analyse the relationship between two stylized empirical facts for stock returns: Unconditional long-term mean reversion and predictability by variables such as the dividend-price ratio or the short-term interest rate. In particular, I show that if one imposes that returns satisfy long-term mean reversion, this implies an upper bound on the predictive regression R-square. If a predictive regression is intended as a motivational building block for theoretical modelling, and the R-square bound is violated, one should recognize that the implied returns process violate long-term mean reversion. Empirical results show that the proposed bound is binding for several leading predictors.

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