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Predicting Returns With Financial Ratios

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  • Lewellen, Jonathan
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    Abstract

    This article provides a new test of the predictive ability of aggregate financial ratios. Predictive regressions are subject to small-sample biases, but the correction in previous studies can substantially understate forecasting power. Dividend yield predicts aggregate market returns from 1946 Â€Ó 2000, as well as in various subperiods. Book-to-market and the earnings-price ratio predict returns during the shorter 1963 Â€Ó 2000 sample. The evidence remains strong despite the unusual price run-up in recent years

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    File URL: http://hdl.handle.net/1721.1/1805
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    Bibliographic Info

    Paper provided by Massachusetts Institute of Technology (MIT), Sloan School of Management in its series Working papers with number 4374-02.

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    Date of creation: 27 Jan 2003
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    Handle: RePEc:mit:sloanp:1805

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    Postal: MASSACHUSETTS INSTITUTE OF TECHNOLOGY (MIT), SLOAN SCHOOL OF MANAGEMENT, 50 MEMORIAL DRIVE CAMBRIDGE MASSACHUSETTS 02142 USA
    Phone: 617-253-2659
    Web page: http://mitsloan.mit.edu/
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    Postal: MASSACHUSETTS INSTITUTE OF TECHNOLOGY (MIT), SLOAN SCHOOL OF MANAGEMENT, 50 MEMORIAL DRIVE CAMBRIDGE MASSACHUSETTS 02142 USA

    Related research

    Keywords: Predictive Regressions; Expected Returns; Small-sample Bias;

    References

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    1. Kothari, S P & Shanken, Jay & Sloan, Richard G, 1995. " Another Look at the Cross-Section of Expected Stock Returns," Journal of Finance, American Finance Association, vol. 50(1), pages 185-224, March.
    2. Robert F. Stambaugh, 1999. "Predictive Regressions," NBER Technical Working Papers 0240, National Bureau of Economic Research, Inc.
    3. Hamilton, James D. & Whiteman, Charles H., 1985. "The observable implications of self-fulfilling expectations," Journal of Monetary Economics, Elsevier, vol. 16(3), pages 353-373, November.
    4. Robert P. Flood & Robert J. Hodrick, 1986. "Asset Price Volatility, Bubbles, and Process Switching," NBER Working Papers 1867, National Bureau of Economic Research, Inc.
    5. Goetzmann, William Nelson & Jorion, Philippe, 1993. " Testing the Predictive Power of Dividend Yields," Journal of Finance, American Finance Association, vol. 48(2), pages 663-79, June.
    6. Andrew Ang & Geert Bekaert, 2001. "Stock Return Predictability: Is it There?," NBER Working Papers 8207, National Bureau of Economic Research, Inc.
    7. Eugene Fama & F. & Kenneth R. French, . "The Equity Premium."," CRSP working papers 522, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
    8. Flood, Robert P & Hodrick, Robert J, 1990. "On Testing for Speculative Bubbles," Journal of Economic Perspectives, American Economic Association, vol. 4(2), pages 85-101, Spring.
    9. Diba, Behzad T & Grossman, Herschel I, 1988. "Explosive Rational Bubbles in Stock Prices?," American Economic Review, American Economic Association, vol. 78(3), pages 520-30, June.
    10. Owen Lamont, . "Earnings and Expected Returns," CRSP working papers 345, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
    11. Fama, Eugene F. & French, Kenneth R., 1988. "Dividend yields and expected stock returns," Journal of Financial Economics, Elsevier, vol. 22(1), pages 3-25, October.
    12. Kothari, S. P. & Shanken, Jay, 1997. "Book-to-market, dividend yield, and expected market returns: A time-series analysis," Journal of Financial Economics, Elsevier, vol. 44(2), pages 169-203, May.
    13. Gregory Mankiw, N. & Shapiro, Matthew D., 1986. "Do we reject too often? : Small sample properties of tests of rational expectations models," Economics Letters, Elsevier, vol. 20(2), pages 139-145.
    14. DeJong, David N & Whiteman, Charles H, 1991. "The Temporal Stability of Dividends and Stock Prices: Evidence from the Likelihood Function," American Economic Review, American Economic Association, vol. 81(3), pages 600-617, June.
    15. Nelson, Charles R & Kim, Myung J, 1993. " Predictable Stock Returns: The Role of Small Sample Bias," Journal of Finance, American Finance Association, vol. 48(2), pages 641-61, June.
    16. Hodrick, Robert J, 1992. "Dividend Yields and Expected Stock Returns: Alternative Procedures for Inference and Measurement," Review of Financial Studies, Society for Financial Studies, vol. 5(3), pages 357-86.
    17. Pontiff, Jeffrey & Schall, Lawrence D., 1998. "Book-to-market ratios as predictors of market returns," Journal of Financial Economics, Elsevier, vol. 49(2), pages 141-160, August.
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    Cited by:
    1. Erik Hjalmarsson, 2006. "Predictive regressions with panel data," International Finance Discussion Papers 869, Board of Governors of the Federal Reserve System (U.S.).
    2. Lettau, Martin & Ludvigson, Sydney C., 2005. "Expected returns and expected dividend growth," Journal of Financial Economics, Elsevier, vol. 76(3), pages 583-626, June.
    3. Andrew Ang & Jun Liu, 2007. "Risk, Return and Dividends," NBER Working Papers 12843, National Bureau of Economic Research, Inc.
    4. Amihud, Yakov & Hurvich, Clifford M., 2004. "Predictive Regressions: A Reduced-Bias Estimation Method," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 39(04), pages 813-841, December.
    5. Campbell, John & Yogo, Motohiro, 2006. "Efficient tests of stock return predictability," Scholarly Articles 3122601, Harvard University Department of Economics.
    6. Cheolbeom Park, 2006. "The Persistence and Predictive Power of the Dividend-Price Ratio," Departmental Working Papers wp0603, National University of Singapore, Department of Economics.
    7. Ivo Welch & Amit Goyal, 2004. "A Note On 'Predicting Returns With Financial Ratios'," Yale School of Management Working Papers amz2465, Yale School of Management.
    8. Hjalmarsson, Erik, 2005. "On the Predictability of Global Stock Returns," Working Papers in Economics 161, University of Gothenburg, Department of Economics.
    9. Park, Cheolbeom, 2010. "When does the dividend-price ratio predict stock returns?," Journal of Empirical Finance, Elsevier, vol. 17(1), pages 81-101, January.
    10. John Y. Campbell, 2002. "Consumption-Based Asset Pricing," Harvard Institute of Economic Research Working Papers 1974, Harvard - Institute of Economic Research.
    11. Yakov Amihud & Clifford Hurvich & Yi Wang, 2004. "Hypothesis Testing in Predictive Regressions," Finance 0412022, EconWPA.

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