Bonferroni‐Type Tests for Return Predictability With Possibly Trending Predictors

ABSTRACT The Bonferroni test is widely used in empirical studies investigating predictability in asset returns by strongly persistent and endogenous predictors. Its formulation, however, only allows for a constant mean in the predictor, seemingly at odds with many of the predictors used in practice. We establish the asymptotic size and local power properties of the test, and the corresponding Bonferroni ‐test, under a local‐to‐zero specification for a linear trend in the predictor, revealing that size and power depend on the magnitude of the trend for both. To rectify this, we develop with‐trend variants of the operational Bonferroni and tests. However, where a trend is not present in the predictor, we show that these tests lose (both finite sample and asymptotic local) power relative to the extant constant‐only versions of the tests. In practice, uncertainty will necessarily exist over whether a linear trend is genuinely present in the predictor or not. To deal with this, we also develop hybrid tests based on union‐of‐rejections and switching mechanisms to capitalise on the relative power advantages of the constant‐only tests when a trend is absent (or very weak) and the with‐trend tests otherwise. A further extension allows the use of a conventional ‐test where the predictor appears to be weakly persistent. We show that, overall, our recommended hybrid test can offer excellent size and power properties regardless of whether or not a linear trend is present in the predictor, or the predictor's degrees of persistence and endogeneity. An empirical application illustrates the practical relevance of our new approach. JEL Classifications: C22, C12, G14