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Long-horizon equity return predictability: some new evidence for the United Kingdom

  • Anne Vila Wetherilt
  • Simon Wells

This paper revisits the issue of long-horizon equity return predictability for the United Kingdom in the context of the dynamic dividend discount model of Campbell and Shiller. This model attributes predictable variation in equity prices to predictable variation in expected returns. The model is supported by the theoretical asset pricing literature, which shows how the variation in expected returns can be related to investors' time-varying preferences for risk. The paper considers various empirical specifications that are consistent with the Campbell and Shiller model and finds that they are supported by UK equity data. In particular, there is weak evidence that the dividend yield has predictive ability for long-horizon excess returns. The paper also examines some of the econometric issues brought up by recent research, in particular the small-sample bias, and applies appropriate statistical corrections. It further shows that the model's predictive ability depends greatly on the sample period over which the model is estimated.

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File URL: http://www.bankofengland.co.uk/research/Documents/workingpapers/2004/WP244.pdf
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Paper provided by Bank of England in its series Bank of England working papers with number 244.

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Date of creation: Nov 2004
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Handle: RePEc:boe:boeewp:244
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  1. Amit Goyal & Ivo Welch, 2003. "Predicting the Equity Premium with Dividend Ratios," Management Science, INFORMS, vol. 49(5), pages 639-654, May.
  2. John Y. Campbell & Robert J. Shiller, 1988. "Stock Prices, Earnings and Expected Dividends," Cowles Foundation Discussion Papers 858, Cowles Foundation for Research in Economics, Yale University.
  3. Lettau, Martin & Ludvigson, Sydney C., 2005. "Expected returns and expected dividend growth," Journal of Financial Economics, Elsevier, vol. 76(3), pages 583-626, June.
  4. Pesaran, M. Hashem & Timmermann, Allan, 2002. "Market timing and return prediction under model instability," Journal of Empirical Finance, Elsevier, vol. 9(5), pages 495-510, December.
  5. Owen Lamont, . "Earnings and Expected Returns," CRSP working papers 345, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
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  8. Lettau, Martin & Ludvigson, Sydney, 1999. "Consumption, Aggregate Wealth and Expected Stock Returns," CEPR Discussion Papers 2223, C.E.P.R. Discussion Papers.
  9. Wayne E. Ferson & Sergei Sarkissian & Timothy Simin, 2002. "Spurious Regressions in Financial Economics?," NBER Working Papers 9143, National Bureau of Economic Research, Inc.
  10. Pesaran, M Hashem & Timmermann, Allan, 1995. " Predictability of Stock Returns: Robustness and Economic Significance," Journal of Finance, American Finance Association, vol. 50(4), pages 1201-28, September.
  11. Lucy F. Ackert & William C. Hunter, 2000. "An empirical examination of the price-dividend relation with dividend management," Working Paper Series WP-00-22, Federal Reserve Bank of Chicago.
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  13. John Y. Campbell, Robert J. Shiller, 1988. "The Dividend-Price Ratio and Expectations of Future Dividends and Discount Factors," Review of Financial Studies, Society for Financial Studies, vol. 1(3), pages 195-228.
  14. 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.
  15. John Y. Campbell & Robert J. Shiller, 2001. "Valuation Ratios and the Long-run Stock Market Outlook: An Update," Cowles Foundation Discussion Papers 1295, Cowles Foundation for Research in Economics, Yale University.
  16. Robert F. Stambaugh, 1999. "Predictive Regressions," NBER Technical Working Papers 0240, National Bureau of Economic Research, Inc.
  17. 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.
  18. Lior Menzly & Tano Santos & Pietro Veronesi, 2004. "Understanding Predictability," Journal of Political Economy, University of Chicago Press, vol. 112(1), pages 1-47, February.
  19. Fama, Eugene F. & French, Kenneth R., 1989. "Business conditions and expected returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 25(1), pages 23-49, November.
  20. Hansen, Lars Peter & Hodrick, Robert J, 1980. "Forward Exchange Rates as Optimal Predictors of Future Spot Rates: An Econometric Analysis," Journal of Political Economy, University of Chicago Press, vol. 88(5), pages 829-53, October.
  21. John B. Carlson & Eduard A. Pelz & Mark E. Wohar, 2001. "Will the valuation ratios revert to their historical means? Some evidence from breakpoint tests," Working Paper 0113, Federal Reserve Bank of Cleveland.
  22. William R. Nelson, 1999. "The aggregate change in shares and the level of stock prices," Finance and Economics Discussion Series 1999-08, Board of Governors of the Federal Reserve System (U.S.).
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