Introduction Literature overview

Stylized Facts about Predictability

aggregate stock returns are predictable by the dividend yield dividend growth rate is only weakly predicted almost all variation of the dividend yield is explained by expected returns stronger predictability at longer horizons due to the persistence of the predictive component out of sample forecasts for returns are poor the forecasting relationship of returns and nancial ratios exhibits signicant instability over time

Ioana Dumitrescu, Kailin Zeng, Claudia Zunft

Asset Return Predictability

Introduction Literature overview

Traditional View

returns are unpredictable

constant equity premium market volatility does not change much

predictability was thought to go against the ecient market hypothesis

Ioana Dumitrescu, Kailin Zeng, Claudia Zunft

Asset Return Predictability

Introduction Literature overview

Modern Research

literature about return predictability predictability not as a challenge to market eciency but as a sign that expected returns are time-varying what explains time-varying expected returns? why should expected returns be time-varying in equilibrium? this can come from time varying risk aversion (as in habit models) or long run risks alternative view: investors' behavioral bias (under- and overreaction, gradual information diusion, investor sentiment) can trigger predictability

Ioana Dumitrescu, Kailin Zeng, Claudia Zunft

Asset Return Predictability

Introduction Literature overview

The Campbell-Shiller Approximation I

The beginnings: static Gordon(1962) model

D =r g P

Dynamic Gordon model

rt+1 k + log (Pt+1 ) + (1 )log (Dt+1 ) log (Pt )

Ioana Dumitrescu, Kailin Zeng, Claudia Zunft

Asset Return Predictability

Introduction Literature overview

The Campbell-Shiller Approximation II

intuition for the CS approximation as a weighted average of prices and dividends (Campbell and Shiller 1989) the approximation error depends on the persistence and volatility of t the Taylor expansion is taken around the unconditional mean of t stationary dividend yield t dt pt pt and dt are allowed to be non-stationary, but they are required to cointegrate such that t stays stationary

Ioana Dumitrescu, Kailin Zeng, Claudia Zunft

Asset Return Predictability

Introduction Literature overview

The Campbell-Shiller Approximation III

The equation now only consists of stationary variables

rt k + t t+1 + dt

Solving this equation forward yields

k

t
j=1

j1

rt+j
j=1

j1 dt+j + k t+k

This implies
(k) (k) 1 r(k) d + k

Ioana Dumitrescu, Kailin Zeng, Claudia Zunft

Asset Return Predictability

Introduction Literature overview

The Properties of the Dividend Yield

the Campbell-Shiller approximation seemed to do really ne until the high valuation ratios in the late '90s appeared after this the H0 of unit root can not be rejected anymore even at high levels of signicance How to deal with this?

assume that t is very near to unit root but still stationary (Torous, Valkanov, and Yan 2004, Campbell and Yogo 2006) infer that there must be rational speculative bubble, the explosive part of the prices causing the non-stationarity of t (Engsted, Pedersen, and Tanggaard 2012) adapt the statistical inference to deal with anomalous observations (Camponovo, Scaillet, and Trojani 2012) assume a shift in the steady state of t (Lettau and Nieuwerburgh 2008)
Asset Return Predictability 7

Ioana Dumitrescu, Kailin Zeng, Claudia Zunft

Introduction Literature overview

Methodological Issues I

short span of available data data snooping concerns regressors are predetermined but not exogenous (rt + 1 = + xt + t+1 , xt depends on prices at the beginning of t, change of x at end of t+1 reects changes in price from t to t+1, as does rt+1 or E ( t+1 |xt+1 , xt ) = 0) persistent valuation ratios, with innovations correlated with returns
biased coecients over-rejection by standard t-test

Ioana Dumitrescu, Kailin Zeng, Claudia Zunft

Asset Return Predictability

Introduction Literature overview

Methodological Issues II

What data to use? dividend-yield? alternative variables are also persistent but less correlated with returns nancial ratios (earnings-price ratio, book-to-market ratio) macroeconomic variables (consumption-wealth ratio, labor income to consumption ratio, housing collateral ratio)

Ioana Dumitrescu, Kailin Zeng, Claudia Zunft

Asset Return Predictability

Introduction Literature overview

Koijen and Nieuwerburgh 2007

set up a present value model the dividend yield is a contaminated predictor (error in variables problem) present-value constraint (one needs to test hypothesis jointly) exploiting correlation in innovations (the data shows that ( r , dp ) is close to -1, while ( , dp ) 0) geometric returns (motivated by CS approximation) vs. arithmetic returns in which investors are interested

Ioana Dumitrescu, Kailin Zeng, Claudia Zunft

Asset Return Predictability

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Introduction Literature overview

Cochrane 2008 I

VAR for log returns, log dividend yields and log dividend growth
rt+1 = ar + r (dt pt ) +
r t+1 d t+1 dp t+1

dt+1 = ad + d (dt pt ) +

dt+1 pt+1 = adp + (dt pt ) +

Link between the 3 variables above given by the CS approx

rt+1 = (pt+1 dt+1 ) + dt+1 (pt dt )

Implications
r = 1 + d
r t+1
Ioana Dumitrescu, Kailin Zeng, Claudia Zunft

d t+1

dp t+1
11

Asset Return Predictability

Introduction Literature overview

Cochrane 2008 II

sets up such a null that returns are not forecastable, dividend growth is evaluates the joint distribution of return and dividend growth forecasting coecients examines also long-run return horizon forecasts strong evidence for return predictability (lack of dividend forecastability gives stronger evidence against the null than return predictability) concludes that excess return forecastability is not a comforting result

Ioana Dumitrescu, Kailin Zeng, Claudia Zunft

Asset Return Predictability

12

Introduction Literature overview

Cochrane 2008 III

WHY? this rules out

tracing price movements back to visible news about dividends or cash ows high prices forecasting dividend growth, such that agents see cash ow information that we do not see high prices triggering low interest rates or other movements in discount factors

return predictability seems to be just enough to account for the volatility of dividend yields, thus excluding bubbles

Ioana Dumitrescu, Kailin Zeng, Claudia Zunft

Asset Return Predictability

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Introduction Literature overview

Lettau and Nieuwerburgh 2008 I

expected returns contain a time-varying component implying predictability of future returns extreme persistence of price ratios expected returns have to be as well persistent if expected returns decay during a lot of years or even decades, as implied by the high persistence of nancial ratios, they are hard to be linked to risk factors like the ones related to business cycles trying to identify slow-moving factors determining equity risk

Ioana Dumitrescu, Kailin Zeng, Claudia Zunft

Asset Return Predictability

14

Introduction Literature overview

Lettau and Nieuwerburgh 2008 II

it is assumed that the steady-state mean of nancial ratios has changed over the course of the sample period. reasons: changes in the steady-state growth rate of economic fundamentals resulting from permanent technological innovations changes in the expected return of equity caused by factors like better risk sharing, dierent stock market participation, changes in the legislation, lower consumption volatility. idea: persistent changes in fundamentals (somehow motivates the long-run risk literature from a theoretic point of view)

Ioana Dumitrescu, Kailin Zeng, Claudia Zunft

Asset Return Predictability

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Introduction Literature overview

Ang and Bekaert 2007

dividend-yield variability can be attributed to the variation of expected cash ow growth, expected future discount rates or risk premia main ndings: inference at long horizons critically depends on the choice of standard errors, short rate is also a predictive variable for future excess returns (signicant only at short horizons) use earning yields instead of dividends, argument: dividends potentially poor instruments, because manipulated or smoothed non-linear present value model with stochastic discount rates, short rate and dividend growth
Ioana Dumitrescu, Kailin Zeng, Claudia Zunft Asset Return Predictability 16

Introduction Literature overview

Two Papers Very Close to the One We Replicate

Chen 2009

Rytchkov 2008

Ioana Dumitrescu, Kailin Zeng, Claudia Zunft

Asset Return Predictability

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Introduction Literature overview

Chen 2009 I

part of the lack of div growth predictability stems from how it has been constructed stock returns more volatile than pure dividend growth, possibly burying the predictability of the latter reinvestment in the market assumption makes the dividend growth behave as returns do (by increasing the correlation bewteen the two) and buries the dividend growth predictability

Ioana Dumitrescu, Kailin Zeng, Claudia Zunft

Asset Return Predictability

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Introduction Literature overview

Chen 2009 II

three ways of checking for predictability:

1 2 3

linear regressions similar to Ang and Bekaert 2007 rolling regressions similar to Goyal and Welch 2008 joint hypothesis similar to Cochrane 2008

shows that return predictability is mainly a postwar phenomenon, was not the case before

Ioana Dumitrescu, Kailin Zeng, Claudia Zunft

Asset Return Predictability

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Introduction Literature overview

Chen 2009 III

two periods:
pre-war:
dividend yield mainly driven by variation of expected future cash-ows relatively unpredictable discount rates less volatile dividend growth volatile and predictable discount rates

post-war:

why did predictability change? (robustness checks)

more rms changing the market index composition changing dividend policy reduced dividend growth policy shift of the steady state of the dividend yield

none of the above

Ioana Dumitrescu, Kailin Zeng, Claudia Zunft Asset Return Predictability 20

Introduction Literature overview

Rytchkov 2008 I

why do we need a Kalman lter? evidence of structural breaks in the data, Kalman lter is more robust to this than standard OLS why to take returns in logs? consistent with theory, distribution of log returns closer to normal, ML approach relies on the distributional assumption, logs are more homoskedastic why one year horizon? shorter horizon: problem with the seasonality in dividend growth, longer than 1 year: overlapping returns, even the asymptotic distribution will have a non-standard form, this will increase the evidence in favor of predictability
Ioana Dumitrescu, Kailin Zeng, Claudia Zunft Asset Return Predictability 21

Introduction Literature overview

Rytchkov 2008 II

Main Findings returns are predictable the correlation between expected returns and expected dividend growth is high and positive

Ioana Dumitrescu, Kailin Zeng, Claudia Zunft

Asset Return Predictability

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