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

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.