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Predicting market returns using aggregate implied cost of capital

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  • Li, Yan
  • Ng, David T.
  • Swaminathan, Bhaskaran

Abstract

Theoretically, the implied cost of capital (ICC) is a good proxy for time-varying expected returns. We find that aggregate ICC strongly predicts future excess market returns at horizons ranging from one month to four years. This predictive power persists even in the presence of popular valuation ratios and business cycle variables, both in-sample and out-of-sample, and is robust to alternative implementations. We also find that ICCs of size and book-to-market portfolios predict corresponding portfolio returns.

Suggested Citation

  • Li, Yan & Ng, David T. & Swaminathan, Bhaskaran, 2013. "Predicting market returns using aggregate implied cost of capital," Journal of Financial Economics, Elsevier, vol. 110(2), pages 419-436.
  • Handle: RePEc:eee:jfinec:v:110:y:2013:i:2:p:419-436
    DOI: 10.1016/j.jfineco.2013.06.006
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    Cited by:

    1. Jäckel, Christoph, 2013. "Model uncertainty and expected return proxies," MPRA Paper 51978, University Library of Munich, Germany.
    2. Kryzanowski, Lawrence & Mohsni, Sana, 2015. "Earnings forecasts and idiosyncratic volatilities," International Review of Financial Analysis, Elsevier, vol. 41(C), pages 107-123.
    3. Zolotoy, Leon & Frederickson, James R. & Lyon, John D., 2017. "Aggregate earnings and stock market returns: The good, the bad, and the state-dependent," Journal of Banking & Finance, Elsevier, vol. 77(C), pages 157-175.
    4. Faria, Gonçalo & Verona, Fabio, 2018. "Forecasting stock market returns by summing the frequency-decomposed parts," Journal of Empirical Finance, Elsevier, vol. 45(C), pages 228-242.
    5. Kruttli, Mathias S., 2016. "From Which Consumption-Based Asset Pricing Models Can Investors Profit? Evidence from Model-Based Priors," Finance and Economics Discussion Series 2016-027, Board of Governors of the Federal Reserve System (U.S.), revised 26 Sep 2016.
    6. Zhi Da & Ravi Jagannathan & Jianfeng Shen, 2014. "Growth Expectations, Dividend Yields, and Future Stock Returns," NBER Working Papers 20651, National Bureau of Economic Research, Inc.
    7. Frank, Murray Z. & Shen, Tao, 2016. "Investment and the weighted average cost of capital," Journal of Financial Economics, Elsevier, vol. 119(2), pages 300-315.
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    10. repec:eee:intfin:v:51:y:2017:i:c:p:15-38 is not listed on IDEAS
    11. Gonçalo Faria & Fabio Verona, 2016. "Forecasting the equity risk premium with frequency-decomposed predictors," Working Papers de Economia (Economics Working Papers) 06, Católica Porto Business School, Universidade Católica Portuguesa.
    12. Faria, Gonçalo & Verona, Fabio, 2018. "The equity risk premium and the low frequency of the term spread," Research Discussion Papers 7/2018, Bank of Finland.
    13. Cetorelli, Nicola & Traina, James, 2018. "Resolving “Too Big to Fail”," Staff Reports 859, Federal Reserve Bank of New York.
    14. repec:kap:fmktpm:v:32:y:2018:i:1:d:10.1007_s11408-017-0302-3 is not listed on IDEAS
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    More about this item

    Keywords

    Implied cost of capital; Market predictability; Valuation ratios;

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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