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.