Statistical and economic significance of stock return predictability: A mean-variance analysis

We use mean-variance analysis to investigate the statistical and economic significance of stock return predictability as documented in Fama and French (1992). We ask if investors who form portfolios conditioned on the predictive variables can earn higher expected utility than those who optimize unconditionally. The result shows that, by and large, they cannot. We explore the reasons for the lack of economic gains and find that, while the in-sample relation between returns and predetermined firm-specific variables is strong, it is not stable enough to produce better out-of-sample predictions. We conclude that the return predictability is not inconsistent with rational asset pricing.