Level‐shifts and non‐linearity in US financial ratios: Implications for returns predictability and the present value model

Abstract

Purpose

The recent unprecedented levels reached by financial ratios have led to a re‐examination of their time‐series properties, with evidence of long memory and nonlinearity reported. The purpose of this paper is to re‐examine the nature of these series in the light of potential time‐variation in the unconditional mean.

Design/methodology/approach

The paper uses econometric techniques designed to capture fractional integration, nonlinearity and time‐variation in the unconditional mean level of a series.

Findings

Reported results support such time‐variation, with cyclical behaviour evident in the unconditional mean of each ratio. Evidence of nonlinearity is still apparent in the mean‐adjusted series.

Research limitations/implications

A key result that arises is that accounting for this time‐variation appears to provide improved long horizon returns predictability.

Originality/value

The paper demonstrates that a nonlinear model incorporating a time‐varying mean improves returns predictability. This is of interest to market participants.

Citation

McMillan, D.G. (2010), "Level‐shifts and non‐linearity in US financial ratios: Implications for returns predictability and the present value model", Review of Accounting and Finance, Vol. 9 No. 2, pp. 189-207. https://doi.org/10.1108/14757701011044198