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Predicting the equity premium with dividend ratios: Reconciling the evidence

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  • Kellard, Neil M.
  • Nankervis, John C.
  • Papadimitriou, Fotios I.
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    Abstract

    This paper evaluates the ability of dividend ratios to predict the equity premium. We conduct an in and out-of-sample comparative study and apply the Goyal and Welch (2003) graphical method to equity premia derived from the UK FTSE All-Share and the S&P 500 indices. Preliminary in-sample univariate regressions reveal that in both markets the equity premium contains an element of predictability. However, the considered out-of-sample models outperform the historical moving average only in the UK context. This is confirmed by the graphical diagnostic which further indicates that dividend ratios are useful predictors of UK excess returns. Our paper provides a possible explanation of why dividend ratios might be more informative in the UK market by linking these findings to the disappearing dividend phenomenon. Finally, Campbell and Shiller (1988) identities are employed to account for the time-varying properties of the dividend ratio and dividend growth processes. It is shown that by instrumenting the models with the identities, forecasting ability can be further improved.

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Empirical Finance.

    Volume (Year): 17 (2010)
    Issue (Month): 4 (September)
    Pages: 539-551

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    Handle: RePEc:eee:empfin:v:17:y:2010:i:4:p:539-551

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    Web page: http://www.elsevier.com/locate/jempfin

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    Keywords: Equity premium Stock return predictability Dividend ratios Out-of-sample prediction;

    References

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    1. Sydney Ludvigson & Martin Lettau, 1999. "Consumption, aggregate wealth and expected stock returns," Staff Reports 77, Federal Reserve Bank of New York.
    2. Lewellen, Jonathan, 2004. "Predicting returns with financial ratios," Journal of Financial Economics, Elsevier, vol. 74(2), pages 209-235, November.
    3. Amihud, Yakov & Li, Kefei, 2006. "The Declining Information Content of Dividend Announcements and the Effects of Institutional Holdings," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 41(03), pages 637-660, September.
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    7. Martin Lettau & Stijn Van Nieuwerburgh, 2006. "Reconciling the Return Predictability Evidence," 2006 Meeting Papers 29, Society for Economic Dynamics.
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    17. Bossaerts, Peter & Hillion, Pierre, 1999. "Implementing Statistical Criteria to Select Return Forecasting Models: What Do We Learn?," Review of Financial Studies, Society for Financial Studies, vol. 12(2), pages 405-28.
    18. David G. McMillan, 2003. "Non-linear Predictability of UK Stock Market Returns," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, vol. 65(5), pages 557-573, December.
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    Cited by:
    1. Nuno Silva, 2013. "Equity Premia Predictability in the EuroZone," GEMF Working Papers 2013-22, GEMF - Faculdade de Economia, Universidade de Coimbra.
    2. Goodness C. Aye & Rangan Gupta & Mampho P. Modise, 2012. "Structural Breaks and Predictive Regressions Models of South African Equity Premium," Working Papers 201209, University of Pretoria, Department of Economics.
    3. Guidolin, Massimo & McMillan, David G. & Wohar, Mark E., 2013. "Time varying stock return predictability: Evidence from US sectors," Finance Research Letters, Elsevier, vol. 10(1), pages 34-40.

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