Tests of the predictability of stock returns may be invalid when the predictor variable is persistent and its innovations are highly correlated with returns. This paper develops a pretest to determine whether the conventional t-test leads to incorrect inference and an efficient test of predictability that always leads to correct inference. Although the conventional t-test is highly misleading for the dividend-price and the smoothed earnings-price ratios, we find evidence for predictability using our test. We also find evidence for predictability with the short rate and the long-short yield spread, for which the conventional t-test leads to correct inference
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