REVERSE REGRESSIONS AND LONG-HORIZON FORECASTING
Article first published online: 23 NOV 2011
Copyright © 2011 John Wiley & Sons, Ltd.
Journal of Applied Econometrics
Volume 28, Issue 3, pages 353–371, April/May 2013
How to Cite
Wei, M. and Wright, J. H. (2013), REVERSE REGRESSIONS AND LONG-HORIZON FORECASTING. J. Appl. Econ., 28: 353–371. doi: 10.1002/jae.1274
- Issue published online: 26 MAR 2013
- Article first published online: 23 NOV 2011
- Manuscript Revised: 27 JUL 2011
- Manuscript Received: 15 JUL 2010
Long-horizon predictive regressions in finance pose formidable econometric problems when estimated using available sample sizes. Hodrick in 1992 proposed a remedy that is based on running a reverse regression of short-horizon returns on the long-run mean of the predictor. Unfortunately, this only allows the null of no predictability to be tested, and assumes stationary regressors. In this paper, we revisit long-horizon forecasting from reverse regressions, and argue that reverse regression methods avoid serious size distortions in long-horizon predictive regressions, even when there is some predictability and/or near unit roots. Meanwhile, the reverse regression methodology has the practical advantage of being easily applicable when there are many predictors. We apply these methods to forecasting excess bond returns using the term structure of forward rates, and find that there is indeed some return forecastability. However, confidence intervals for the coefficients of the predictive regressions are about twice as wide as those obtained with the conventional approach to inference. We also include an application to forecasting excess stock returns. Copyright © 2011 John Wiley & Sons, Ltd.