TAILIEUCHUNG - Stock Return Predictability: Is it There?

The emergence of the derivatives market has led to the creation of investment securities with complex cash flow profiles. Investment professionals, using derivatives, can customize a security’s structure to the investor’s risk/reward profile of choice. As a result, investors now have more investment choices. The increasing complexity of many of the securities, however, has complicated asset/liability risk measurement and management decisions. A decline in interest rates can cause significant amounts of prepayments and early redemptions for FHLBanks holding a large percentage of their portfolio in securities with options. The yields. | Stock Return Predictability Is it There Andrew Ang Columbia University and NBER Geert Bekaert Columbia University NBER and CPER We examine the predictive power of the dividend yields for forecasting excess returns cash flows and interest rates. Dividend yields predict excess returns only at short horizons together with the short rate and do not have any long-horizon predictive power. At short horizons the short rate strongly negatively predicts returns. These results are robust in international data and are not due to lack of power. A present value model that matches the data shows that discount rate and short rate movements play a large role in explaining the variation in dividend yields. Finally we find that earnings yields significantly predict future cash flows. JEL C12 C51 C52 E49 F30 G12 In a rational no-bubble model the price-dividend ratio is the expected value of future cash flows discounted with time-varying discount rates. Because price-dividend ratios or dividend yields vary over time dividend yield variability can be attributed to the variation of expected cash flow growth expected future risk-free rates or risk premia. The conventional wisdom in the literature see among others Campbell 1991 Cochrane 1992 is that aggregate dividend yields strongly predict excess returns and the predictability is stronger at longer horizons. 1 Since dividend yields only weakly predict dividend growth conventional wisdom attributes most of the variation of dividend yields to changing forecasts of expected returns. We critically and comprehensively re-examine this conventional wisdom regarding return predictability on the aggregate market. We thank Xiaoyan Zhang for help with data. We thank Kobi Boudoukh Michael Brandt John Campbell John Cochrane George Constantinides Cam Harvey Bob Hodrick Charles Jones Owen Lamont Martin Lettau Jun Liu Sydney Ludvigson Chris Neely Jim Poterba Tano Santos Bob Shiller Tim Simin Ken Singleton Rob Stambaugh Meir Statman Jim Stock Ane Tamayo

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