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Forecasting stock market returns: The sum of the parts is more than
the whole$
Miguel A. Ferreira a,b, Pedro Santa-Clara a,c,
a
b
c
a r t i c l e in f o
abstract
Article history:
Received 20 January 2010
Received in revised form
15 July 2010
Accepted 13 August 2010
Available online 19 February 2011
JEL classication:
G11
G12
G14
Keywords:
Predictability
Stock returns
Equity premium
Predictive regressions
Trading strategies
1. Introduction
A long literature exists on forecasting stock market
returns using price multiples, macroeconomic variables,
We thank an anonymous referee, Michael Brandt, Jules van Binsbergen, John Campbell, John Cochrane, Amit Goyal, Lubos Pastor, Bill
Schwert (the editor), Ivo Welch, Motohiro Yogo, and Jialin Yu; seminar
Frankfurt,
participants at Barclays Global Investors, Goethe Universitat
Hong Kong University of Science and Technology Finance Symposium,
Manchester Business School, BI-Norwegian School of Management, and
University of Piraeus; and participants at the 2009 European Finance
Association Conference, 2010 American Finance Association Conference,
and CSEF-IGIER Symposium on Economics and Institutions for helpful
comments. We are particularly grateful to Carolina Almeida, Filipe
Lacerda, and Tymur Gabuniya for outstanding research assistance. This
research is supported by a grant from the Fundac- a~ o para a Ciencia e
Tecnologia (PTDC/EGE-GES/101414/2008).
Corresponding author.
E-mail address: psc@fe.unl.pt (P. Santa-Clara).
0304-405X/$ - see front matter & 2011 Elsevier B.V. All rights reserved.
doi:10.1016/j.jneco.2011.02.003
1
Researchers who use the dividend yield include Dow (1920), Campbell
(1987), Fama and French (1988), Hodrick (1992), Campbell and Yogo
(2006), Ang and Bekaert (2007), Cochrane (2008), and Binsbergen and
Koijen (2010). The earningsprice ratio is used by Campbell and Shiller
(1988) and Lamont (1998). The book-to-market ratio is used by Kothari and
Shanken (1997) and Pontiff and Schall (1998). The short-term interest rate is
used by Fama and Schwert (1977), Campbell (1987), Breen, Glosten, and
Jagannathan (1989), and Ang and Bekaert (2007). Ination is used by Nelson
(1976), Fama and Schwert (1977), Ritter and Warr (2002), and Campbell and
Vuolteenaho (2004). The term and default yield spreads are used
by Campbell (1987) and Fama and French (1988). The consumptionwealth
ratio is used by Lettau and Ludvigson (2001). Corporate issuing activity is
used by Baker and Wurgler (2000) and Boudoukh, Michaely, Richardson, and
Roberts (2007). Stock volatility is used by French, Schwert, and Stambaugh
(1987), Goyal and Santa-Clara (2003), Ghysels, Santa-Clara, and Valkanov
(2005), and Guo (2006).
the grounds that the persistence of the forecasting variables and the correlation of their innovations with returns
might bias the regression coefcients and affect t-statistics (Nelson and Kim, 1993; Cavanagh, Elliott, and Stock,
1995; Stambaugh, 1999; Lewellen, 2004). A further problem is the possibility of data mining illustrated by a long
list of spurious predictive variables that regularly show up
in the press, including hemlines, football results, and
butter production in Bangladesh (Foster, Smith, and
Whaley, 1997; Ferson, Sarkissian, and Simin, 2003). The
predictability of stock market returns thus remains an
open question.
In important recent research, Goyal and Welch (2008)
examine the out-of-sample performance of a long list of
predictors. They compare forecasts of returns at time t+ 1
from a predictive regression estimated using data up to
time t with forecasts based on the historical mean in the
same period. They nd that the historical mean has better
out-of-sample performance than the traditional predictive regressions. Goyal and Welch (2008) conclude that
these models would not have helped an investor with
access only to available information to protably time the
market (p. 1455) (see also Bossaerts and Hillion, 1999).
While Inoue and Kilian (2004) and Cochrane (2008) argue
that this is not evidence against predictability per se but
only evidence of the difculty in exploiting predictability
with trading strategies, the Goyal and Welch (2008)
challenge remains largely unanswered.
We offer an alternative approach to predict stock market
returns: the sum-of-the-parts (SOP) method. We decompose the stock market return into three componentsthe
dividendprice ratio, the earnings growth rate, and the
priceearnings ratio growth rateand forecast each component separately, exploiting their different time series
characteristics. Because the dividendprice ratio is highly
persistent, we forecast it using the currently observed
dividendprice ratio. Because earnings growth is close to
unpredictable in the short-run but has a low-frequency
predictable component (Binsbergen and Koijen, 2010), we
forecast it using its long-run historical average (20-year
moving average). Finally, we assume no growth in the
priceearnings ratio in this simplest version of the SOP
method. This ts closely with the random walk hypothesis
for the dividendprice ratio. Thus, the return forecast equals
the sum of the current dividendprice ratio and the longrun historical average of earnings growth.2
We apply the SOP method using the same data
as Goyal and Welch (2008) for the 19272007 period.3
Our approach clearly performs better than both the
historical mean and the traditional predictive regressions.
2
We also use two alternatives to predict the growth rate in the
priceearnings ratio. In the rst alternative, we use predictive regressions for the growth rate in the priceearnings ratio. In the second
alternative, we regress the priceearnings ratio on macroeconomic
variables and calculate the growth rate that would make the currently
observed ratio revert to the tted value. There is some improvement in
the out-of-sample performance of the SOP method from using these
alternatives.
3
The sample period in Goyal and Welch (2008) is 19272004. We
use the more recent data, but the results improve if we use only the
19272004 period.
515
516
m^ s a^ b^ xs :
We follow this process for s= s0,y,T 1, thereby generating a sequence of out-of-sample return forecasts m^ s . To
start the procedure, we require an initial sample of size s0
4
Alternatives to predictive regressions based on Bayesian methods,
latent variables, analyst forecasts, and surveys have been suggested
by Welch (2000), Claus and Thomas (2001), Brandt and Kang
(2004), Pastor and Stambaugh (2009), and Binsbergen and Koijen (2010).
5
To be more rigorous, we should index the estimated coefcients of
the regression by s, a^ s , and b^ s , as they change with the expanding
sample. We suppress the subscript s for simplicity.
MSEP
,
MSEM
T 1
1 X
rs 1 m^ s 2 ,
Ts0 s s0
T 1
1 X
rs 1 r s 2 ,
Ts0 s s0
^ ge ^ dp
m^ s m^ gm
s ms ms :
Pt 1 Dt 1
,
Pt
Pt
Pt
Pt =Et
Et
Mt Et
1 GM t 1 1 GEt 1 ,
1 CGt 1
Dt 1
Dt 1 Pt 1
DP t 1 1 GMt 1 1 GEt 1 ,
Pt
Pt 1 Pt
9
517
13
m^ s g s dps ,
14
rt 1 a bdpt et 1 ,
10
11
15
518
Table 1
Summary statistics of return components.
This table reports mean, median, standard deviation, minimum, maximum, skewness, kurtosis, and rst-order autocorrelation coefcient of the
realized components of stocks market returns. gm is the growth in the priceearnings ratio. ge is the growth in earnings. dp is the dividendprice ratio.
r is the stock market return. The sample period is from December 1927 through December 2007.
Panel A: Univariate statistics
Return
components
Mean
Median
Standard
deviation
Minimum
Maximum
Skewness
Kurtosis
30.41
9.52
0.09
33.88
36.71
15.12
1.27
34.82
0.05
0.23
1.15
0.43
9.74
8.19
6.84
11.19
0.16
0.88
0.98
0.08
62.26
70.56
1.13
60.97
78.83
56.90
9.62
43.60
0.27
1.02
0.75
0.97
3.12
5.42
3.99
4.50
0.17
0.17
0.79
0.09
AR(1)
Panel B: Correlations
Return
components
gm
ge
dp
519
7
6
5
4
3
2
1
55
51
59
19
63
19
67
19
71
19
75
19
79
19
83
19
87
19
91
19
95
19
99
20
03
20
07
19
19
19
19
47
Fig. 1. Cumulative realized stock market components. This gure shows of annual realized priceearnings ratio growth (gm), earnings growth (ge),
dividend price (dp), and stock market return (r) index (base year is 1947= 1).
520
Table 2
Forecasts of stock market returns.
This table presents in-sample and out-of-sample R-squares (in percentage) for stock market return forecasts at monthly and annual
(nonoverlapping) frequencies from predictive regressions and the sumof-the-parts (SOP) method with no multiple growth. The in-sample
R-squares are estimated over the full-sample period. The out-of-sample
R-squares compare the forecast error of the model with the forecast
error of the historical mean. The sample period is from December 1927
through December 2007. Forecasts begin 20 years after the sample start.
Asterisks denote signicance of the in-sample regression as measured by
the F-statistic or signicance of the out-of-sample MSEF statistic
of McCracken (2007). nnn, nn, and n denote signicance at the 1%, 5%,
and 10% level, respectively.
Variable
Description
In-sample
R-square
Out-of-sample
R-square
0.05
0.08
0.02
0.17
No shrinkage Shrinkage
0.10
0.02
0.35
0.05
1.19
0.09
0.98
0.05
0.04
0.08
0.00
0.03
1.07nnn
0.07
0.34n
0.76nnn
0.74nn
0.15
0.23
0.58nn
0.07
0.05
0.59
0.21
0.69nnn
0.05
0.63
0.51
1.25
0.18
0.58
1.78
0.02
0.04
0.10
0.03
0.50nn
0.03
0.11
0.53nn
0.02
0.04
0.07
0.06
1.32nnn
13.43nnn
15.0
521
Dividend price
Earnings growth
Market return
12.5
10.0
7.5
5.0
2.5
19
19
48
52
19
56
19
60
19
64
19
68
19
72
19
76
19
80
19
84
19
88
19
92
19
96
20
00
20
04
0.0
15.0
T-bill rate
Market return forecast
12.5
10.0
7.5
5.0
2.5
60
19
64
19
68
19
72
19
76
19
80
19
84
19
88
19
92
19
96
20
00
20
04
19
56
19
52
19
19
48
0.0
30
25
20
15
10
5
0
56
19
60
19
64
19
68
19
72
19
76
19
80
19
84
19
88
19
92
19
96
20
00
20
04
19
52
19
19
4
-5
Fig. 2. SOP stock market return forecast. The top panel shows the forecast of earnings growth (ge), dividend price (dp), and market return (ge + dp) from
the sum-of-the-parts (SOP) method with no multiple growth. The middle panel shows the Treasury bill rate (TBL) and the market return forecast from the
SOP method with no multiple growth. The bottom panel shows the market return forecast from the SOP method with no multiple growth and the
subsequent ve-year average realized market return.
15
The true out-of-sample R-squares of the constrained regressions
are 5.09% and 1.96%, respectively. There is therefore a gain relative to the
unconstrained regression that reects the lower estimation error in the
constrained regressions. Still, the out-of-sample R-squares are substantially lower than the one obtained with the SOP method with no
multiple growth, 13.43%.
that both components are responsible for the performance of the SOP method.
The same conclusion is supported by a variance
decomposition of expected returns. We calculate the
share of each component in the variance of expected
returns estimated from the SOP method:
1
:
Varm^ s
Varm^ s
Varm^ s
16
522
DP
15.0
12.5
10.0
7.5
5.0
2.5
0.0
Historical mean
Predictive regression
SOP no multiple growth
-2.5
68
19
72
19
76
19
80
19
84
19
88
19
92
19
96
20
00
20
04
19
64
60
19
56
19
52
19
19
19
48
-5.0
TMS
15.0
12.5
10.0
7.5
5.0
2.5
0.0
Historical mean
Predictive regression
SOP no multiple growth
-2.5
84
19
88
19
92
19
96
20
00
20
04
80
19
76
19
72
19
19
68
64
19
19
60
19
56
52
19
19
19
48
-5.0
TBL
15.0
12.5
10.0
7.5
5.0
2.5
0.0
Historical mean
Predictive regression
SOP no multiple growth
-2.5
19
60
19
64
19
68
19
72
19
76
19
80
19
84
19
88
19
92
19
96
20
00
20
04
56
52
19
19
19
48
-5.0
Fig. 3. Forecast of stock market return alternative methods. The panels show the forecast of market return from the historical mean, predictive
regressions with dividend price (DP), term spread (TMS), and T-bill rate (TBL) as predictors, and sum-of-the-parts (SOP) method with no multiple growth.
523
Predictive regression
SOP no multiple growth
50
25
0
-25
-50
-75
19
48
19
52
19
56
19
60
19
64
19
68
19
72
19
76
19
80
19
84
19
88
19
92
19
96
20
00
20
04
DP
75
Predictive regression
SOP no multiple growth
50
25
0
-25
-50
56
19
60
19
64
19
68
19
72
19
76
19
80
19
84
19
88
19
92
19
96
20
00
20
04
19
19
19
52
-75
48
TMS
75
Predictive regression
SOP no multiple growth
50
25
0
-25
-50
56
60
19
64
19
68
19
72
19
76
19
80
19
84
19
88
19
92
19
96
20
00
20
04
19
19
19
19
52
-75
48
TBL
75
Fig. 4. Cumulative R-square. The panels show out-of-sample cumulative R-square up to each year from predictive regressions with dividend price (DP),
term spread (TMS), and T-bill rate (TBL) as predictors, and the sum-of-the-parts (SOP) method with no multiple growth relative to the historical mean.
process for the ratio and using the resulting forecast out of
sample. We nd that the autoregressive coefcient
increases throughout the sample, from 0.4 in the beginning
to 0.8 in the end, whereas the SOP method assumes
implicitly that the coefcient is equal to one throughout.
Substantially less persistence was evident in the dividend
price ratio earlier in the sample, and a legitimate concern
exists that investors back then would not have modeled the
dividendprice ratio as a random walk. However, when
we use the autoregressive forecast of the dividendprice
ratio as an alternative to the current ratio, we obtain an
524
ROE
1DE
,
i.e.,
expected
plowback
times
return
s
s
s
on equity. The last component assumes that earnings
growth corresponds to retained earnings times the return
on equity. It is implicitly assumed that there are no external
nancing ows and that the marginal investment opportunities earn the same as the average return on equity.
Campbell and Thompson (2008) use historical averages
to forecast the plowback (or one minus the payout ratio)
and the return on equity. We implement their method in
our sample, and the out-of-sample R-square is 0.54%
(signicant at the 5% level) with monthly frequency and
3.24% (signicant only at the 10% level) with yearly frequency.16 Our method using only the dividendprice ratio
and earnings growth components gives signicantly higher
R-squares: 1.32% with monthly frequency and 13.43% with
yearly frequency. In summary, the SOP substantially
improves the out-of-sample explanatory power relative to
previous studies, and the magnitude of this improvement is
economically meaningful for investors.
17
18
16
Campbell and Thompson (2008) use a longer sample period from
1891 to 2005 (with forecasts beginning in 1927) and obtain out-ofsample R-squares of 0.63% with monthly frequency and 4.35% with
yearly frequency. We thank John Campbell for providing the data and
programs for this comparison.
19
^ s ms m^ s :
u^ s m
20
In practice, the reversion of the multiple to its expectation is quite slow and does not take place in a single
period. To take this into account, we run a second
regression of the realized multiple growth on the
expected multiple growth using the estimated residuals
from regression Eq. (18):
gmt 1 c du^ t vt :
21
22
Table 3
Forecasts of stock market returns: sum-of-the-parts (SOP) extensions.
This table presents in-sample and out-of-sample R-squares (in percentage) for stock market return forecasts at monthly and annual
(nonoverlapping) frequencies from the SOP method with multiple
growth. The out-of-sample R-squares compare the forecast error of the
model with the forecast error of the historical mean. The sample period
is from December 1927 through December 2007. Forecasts begin 20
years after the sample start. Asterisks denote signicance of the insample regression as measured by the F-statistic or signicance of the
out-of-sample MSEF statistic of McCracken (2007). nnn, nn, and n denote
signicance at the 1%, 5%, and 10% level, respectively.
Out-of-sample R-square
Variable
Description
SOP with
multiple
growth
regression
SOP with
multiple
reversion
SEP
Smooth earning
0.94nnn
price
nnn
DP
Dividend price
0.89
DY
Dividend yield
0.76nnn
nnn
BM
Book-to-market
0.68
Constant
1.35nnn
Panel B: Annual return forecasts (19482007)
SVAR
Stock variance
12.74nnn
DFR
Default return
14.40nnn
spread
LTY
Long-term bond
10.92nnn
yield
LTR
Long-term bond
12.62nnn
return
INFL
Ination
12.91nnn
TMS
Term spread
11.28nnn
TBL
T-bill rate
11.51nnn
DFY
Default yield
12.57nnn
spread
NTIS
Net equity
13.31nnn
expansion
ROE
Return on equity
13.66nnn
DE
Dividend payout
12.60nnn
EP
Earnings price
14.31nnn
SEP
Smooth earning
11.07nnn
price
DP
Dividend price
8.99nnn
DY
Dividend yield
12.51nnn
BM
Book-to-market
10.20nnn
Constant
13.65nnn
12.98nnn
7.61nnn
16.94nnn
14.05nnn
15.57nnn
11.67nnn
14.46nnn
14.21nnn
9.02nnn
9.72nnn
14.40nnn
525
526
TMS
50
45
40
35
30
25
20
15
10
19
48
19
52
19
56
19
60
19
64
19
68
19
72
19
76
19
80
19
84
19
88
19
92
19
96
20
00
20
04
TBL
50
45
40
35
30
25
20
15
10
00
04
20
96
20
88
92
19
19
84
19
80
76
72
19
19
19
68
19
19
60
64
19
56
19
52
19
19
19
48
Fig. 5. Realized and forecasted priceearnings ratio. The panels show the realized priceearnings ratio and forecasted priceearnings ratio from the sumof-the-parts (SOP) method with multiple reversion and using term spread (TMS) and T-bill rate (TBL) as predictors.
527
TMS
20
15
10
5
0
52
19
56
19
60
19
64
19
68
19
72
19
76
19
80
19
84
19
88
19
92
19
96
20
00
20
04
19
19
48
-5
TBL
20
15
10
5
0
56
19
60
19
64
19
68
19
72
19
76
19
80
19
84
19
88
19
92
19
96
20
00
20
04
52
19
19
19
48
-5
Fig. 6. Forecast of stock market return alternative sum-of-the-parts (SOP) methods. The panels show the forecast of market return from the SOP method
with no multiple growth, and with multiple growth regression and multiple reversion using term spread (TMS) and T-bill rate (TBL) as predictors.
m^ s rf s 1
,
gs^ 2s
23
24
17
Given the average stock market excess return and variance, a
meanvariance investor with risk-aversion coefcient of 2 would
allocate all wealth to the stock market. This is therefore consistent with
equilibrium with this representative investor. Results are similar when
we use other values for the risk-aversion coefcient.
18
In untabulated results, we obtain slightly better certainty equivalents and Sharpe ratio gains if we impose portfolio constraints preventing investors from shorting stocks ws Z 0% and assuming more than
50% leverage ws r 150%.
ce rp s2 rp,
2
25
528
Table 4
Forecasts of stock market returns: subsamples.
This table presents in-sample and out-of-sample R-squares (in percentage) for stock market return forecasts at monthly and annual (nonoverlapping)
frequencies from predictive regressions and the sum-of-the-parts (SOP) method. The in-sample R-squares are estimated over the full-sample period. The
out-of-sample R-squares compare the forecast error of the model with the forecast error of the historical mean. The sample period is from December
1927 through December 2007. Forecasts begin 20 years after the sample start. The subsamples divide the forecast period in half. Asterisks denote
signicance of the in-sample regression as measured by the F-statistic or signicance of the out-of-sample MSEF statistic of McCracken (2007). nnn, nn,
and n denote signicance at the 1%, 5%, and 10% level respectively.
Out-of-sample R-square
Variable
Description
In-sample
R-square
SVAR
Stock variance
0.00
DFR
Default return spread
0.01
LTY
Long-term bond yield
0.11
LTR
Long-term bond return
0.12
INFL
Ination
0.13
TMS
Term spread
0.12
TBL
T-bill rate
0.17
DFY
Default yield spread
0.01
NTIS
Net equity expansion
1.08nn
ROE
Return on equity
0.01
DE
Dividend payout
0.47n
EP
Earnings price
1.07nn
SEP
Smooth earnings price
1.83nnn
DP
Dividend price
0.24
DY
Dividend yield
0.47n
BM
Book-to-market
1.62nnn
Constant
SVAR
Stock variance
0.19
DFR
Default return spread
2.34
LTY
Long-term bond yield
0.70
LTR
Long-term bond return
6.82n
INFL
Ination
1.49
TMS
Term spread
1.91
TBL
T-bill rate
1.59
DFY
Default yield spread
0.05
NTIS
Net equity expansion
14.91nnn
ROE
Return on equity
0.91
DE
Dividend payout
1.30
EP
Earnings price
6.74n
SEP
Smooth earnings price
22.44nnn
DP
Dividend price
2.93
DY
Dividend yield
5.28
BM
Book-to-market
14.73nnn
Constant
SVAR
Stock variance
0.36
DFR
Default return spread
0.14
LTY
Long-term bond yield
0.05
LTR
Long-term bond return
0.74nn
INFL
Ination
0.03
TMS
Term spread
0.46n
TBL
T-bill rate
0.02
DFY
Default yield spread
1.02nn
NTIS
Net equity expansion
0.85nn
ROE
Return on equity
0.12
DE
Dividend payout
0.00
EP
Earnings price
0.61n
SEP
Smooth earnings price
0.58n
DP
Dividend price
0.56n
DY
Dividend yield
0.61n
BM
Book-to-market
0.17
Constant
Predictive
regression
(shrinkage)
SOP
no multiple
growth
0.18
1.04
1.72
2.20
0.21n
0.24n
0.15
0.53
0.37n
0.17
1.09
0.40
1.45
0.29n
0.07
0.04
0.04
0.22
0.04
0.34
0.08
0.10
0.09
0.09
0.16
0.03
0.02
0.65nn
0.11
0.20n
0.33n
0.39n
1.80nnn
1.64nnn
1.57nnn
1.61nnn
1.42nnn
2.19nnn
2.06nnn
1.90nnn
1.80nnn
1.85nnn
1.74nnn
1.73nnn
2.15nnn
2.06nnn
2.26nnn
2.29nnn
2.28nnn
2.13nnn
2.10nnn
0.93nnn
2.21nnn
2.23nnn
2.18nnn
1.64nnn
2.11nnn
2.12nnn
2.25nnn
2.16nnn
2.14nnn
0.76
4.52n
10.95
9.64n
0.99
6.66
12.14
1.64
0.65
12.62
0.23
14.14nnn
10.42
4.48n
17.74
8.30nnn
0.21
1.66
0.82
5.10nn
0.72
0.68
1.43
0.43
0.31
1.93
0.12
4.71n
5.91nn
1.82
4.34n
4.41n
14.66nnn
13.93nnn
14.82nnn
9.62nn
13.44nnn
13.77nnn
12.80nnn
11.66nn
14.56nnn
14.59nnn
14.73nnn
13.09nnn
21.77nnn
23.21nnn
21.02nnn
18.16nnn
19.87nnn
21.54nnn
20.17nnn
13.40nnn
25.18nnn
22.18nnn
21.85nnn
18.31nnn
21.98nnn
21.75nnn
22.82nnn
21.52nnn
21.76nnn
0.99
0.02
0.74
0.67
0.78
1.63
2.09
0.14
0.53nn
0.88
1.07
0.30n
0.53
1.01
1.31
0.73
0.22
0.00
0.11
0.19n
0.13
0.01
0.26
0.25n
0.58nn
0.09
0.17
0.19n
0.11
0.08
0.08
0.08
0.98nn
0.00
1.00nn
0.93nn
1.17nnn
0.88nn
1.10nnn
0.85nn
1.01nn
1.44nnn
0.62nn
0.74nn
0.87nn
0.62nn
0.32n
0.23n
0.57nn
0.81nn
0.87nn
0.87nn
0.85nn
0.98nn
0.90nn
1.09nnn
0.60nn
0.79nn
0.80nn
0.19
0.86nn
Predictive
regression
SOP
multiple growth
regression
SOP
multiple
reversion
529
Table 4 (continued )
Out-of-sample R-square
Variable
Description
In-sample
R-square
SVAR
Stock variance
DFR
Default return spread
LTY
Long-term bond yield
LTR
Long-term bond return
INFL
Ination
TMS
Term spread
TBL
T-bill rate
DFY
Default yield spread
NTIS
Net equity expansion
ROE
Return on equity
DE
Dividend payout
EP
Earnings price
SEP
Smooth earnings price
DP
Dividend price
DY
Dividend yield
BM
Book-to-market
Constant
0.71
3.15
2.37
3.26
2.24
1.27
0.51
5.71n
2.53
0.45
0.14
8.42nn
7.11n
6.97n
5.69n
3.04
Predictive
regression
Predictive
regression
(shrinkage)
SOP
no multiple
growth
SOP
multiple growth
regression
SOP
multiple
reversion
25.88
5.65
3.39
21.50
10.39
15.70
17.57
14.77
1.53
9.68
9.82
1.82
12.50
26.89
15.74
11.16
1.32
0.58
0.09
0.15
0.80
2.04
2.53
0.22
3.30n
0.43
1.79
3.49n
1.39
0.62
0.52
0.50
12.10nnn
10.83nn
13.56nnn
11.55nnn
12.35nnn
9.64nn
9.92nn
9.24nn
8.83nn
10.76nn
15.32nnn
11.35nnn
9.83nn
5.85nn
0.01
6.60nn
6.33nn
7.28nn
11.51nn
7.37nn
10.09nn
11.64nnn
10.75nn
8.81nn
9.38nn
8.08nn
5.13nn
7.56
9.74nn
530
Table 5
Trading strategies: certainty equivalent gains.
This table presents out-of-sample portfolio choice results at monthly and annual (nonoverlapping) frequencies from predictive regressions and the
sum-of-the-parts (SOP) method. The numbers are the certainty equivalent gains (in percentage) of a trading strategy timing the market with different
2
return forecasts relative to timing the market with the historical mean return. The certainty equivalent return is rpg=2s^ rp with a risk-aversion
coefcient of g 2. All numbers are annualized (monthly certainty equivalent gains are multiplied by 12). The sample period is from December 1927
through December 2007. Forecasts begin 20 years after the sample start.
Variable
Description
Predictive
regression
Predictive
regression
(shrinkage)
SOP
no multiple
growth
SOP
multiple growth
regression
SOP
multiple
reversion
SVAR
Stock variance
0.04
DFR
Default return spread
0.26
LTY
Long-term bond yield
1.56
LTR
Long-term bond return
0.25
INFL
Ination
0.07
TMS
Term spread
0.41
TBL
T-bill rate
0.86
DFY
Default yield spread
0.19
NTIS
Net equity expansion
2.14
ROE
Return on equity
0.28
DE
Dividend payout
1.40
EP
Earnings price
0.20
SEP
Smooth earnings price
1.15
DP
Dividend price
0.84
DY
Dividend yield
1.21
BM
Book-to-market
2.58
Constant
0.00
0.04
0.29
0.10
0.02
0.18
0.18
0.05
0.94
0.17
0.57
0.35
0.41
0.26
0.33
0.52
1.79
0.97
1.75
1.76
1.92
1.86
2.13
1.75
1.53
2.33
1.69
1.56
1.69
0.73
0.62
0.45
0.49
1.61
1.72
1.26
1.68
1.65
1.72
1.38
1.65
1.59
1.18
0.94
1.69
SVAR
Stock variance
DFR
Default return spread
LTY
Long-term bond yield
LTR
Long-term bond return
INFL
Ination
TMS
Term spread
TBL
T-bill rate
DFY
Default yield spread
NTIS
Net equity expansion
ROE
Return on equity
DE
Dividend payout
EP
Earnings price
SEP
Smooth earnings price
DP
Dividend price
DY
Dividend yield
BM
Book-to-market
Constant
0.04
0.20
0.19
0.66
0.08
0.08
0.31
0.01
0.54
0.28
0.24
0.34
0.14
0.22
0.16
0.27
1.82
1.66
2.07
1.75
1.88
1.73
1.52
1.69
1.58
1.89
2.04
1.91
1.66
0.88
0.54
1.41
0.97
1.54
1.51
0.92
1.95
1.47
1.84
1.25
1.65
1.64
0.78
0.74
1.67
0.12
0.48
1.05
1.48
0.08
0.58
1.48
0.01
1.25
1.09
0.60
0.58
1.39
0.71
2.04
1.53
531
Table 6
Trading strategies: Sharpe ratio gains.
This table presents out-of-sample portfolio choice results at monthly and annual (nonoverlapping) frequencies from predictive regressions and the
sum-of-the-parts (SOP) method. The numbers are the change in Sharpe ratio of a trading strategy timing the market with different return forecasts
relative to timing the market with the historical mean return. All numbers are annualized. The sample period is from December 1927 through December
2007. Forecasts begin 20 years after the sample start.
Variable
Description
Predictive
regression
Predictive
regression
(shrinkage)
SOP
no multiple
growth
SOP
multiple growth
regression
SOP
multiple
reversion
SVAR
Stock variance
0.00
DFR
Default return spread
0.06
LTY
Long-term bond yield
0.25
LTR
Long-term bond return
0.12
INFL
Ination
0.04
TMS
Term spread
0.05
TBL
T-bill rate
0.18
DFY
Default yield spread
0.02
NTIS
Net equity expansion
0.04
ROE
Return on equity
0.06
DE
Dividend payout
0.02
EP
Earnings price
0.09
SEP
Smooth earnings price
0.21
DP
Dividend price
0.11
DY
Dividend yield
0.13
BM
Book-to-market
0.34
Constant
0.00
0.01
0.06
0.02
0.01
0.02
0.04
0.00
0.06
0.02
0.00
0.30
0.12
0.08
0.15
0.04
0.31
0.12
0.30
0.29
0.23
0.31
0.28
0.32
0.33
0.28
0.27
0.32
0.23
0.12
0.14
0.07
0.01
0.22
0.24
0.09
0.24
0.19
0.23
0.16
0.24
0.24
0.12
0.14
0.24
SVAR
Stock variance
DFR
Default return spread
LTY
Long-term bond yield
LTR
Long-term bond return
INFL
Ination
TMS
Term spread
TBL
T-bill rate
DFY
Default yield spread
NTIS
Net equity expansion
ROE
Return on equity
DE
Dividend payout
EP
Earnings price
SEP
Smooth earnings price
DP
Dividend price
DY
Dividend yield
BM
Book-to-market
Constant
0.00
0.02
0.03
0.06
0.02
0.02
0.04
0.01
0.04
0.04
0.00
0.15
0.07
0.02
0.07
0.03
0.22
0.23
0.23
0.19
0.23
0.21
0.18
0.19
0.24
0.22
0.16
0.21
0.12
0.06
0.04
0.20
0.09
0.11
0.12
0.02
0.15
0.09
0.15
0.08
0.13
0.12
0.03
0.04
0.13
0.01
0.03
0.14
0.08
0.01
0.10
0.19
0.01
0.05
0.15
0.00
0.05
0.15
0.02
0.21
0.19
mt 1 d0 d1 mt d0 emt 1
26
and
gt 1 g0 g1 gt g0 egt 1 :
27
The dividend growth rate is equal to the expected dividend growth rate plus an orthogonal shock:
4. Simulation analysis
Ddt 1 gt edt 1 :
28
29
532
Table 7
Forecasts of stock market returns: international evidence.
This table presents in-sample and out-of-sample R-squares (in percentage) for stock market return forecasts at annual (nonoverlapping) frequency in
the UK (Panel A), Japan (Panel B), and the US (Panel C) from predictive regressions and the sum-of-the-parts (SOP) method. The in-sample R-squares are
estimated over the full-sample period. The out-of-sample R-squares compare the forecast error of the model with the forecast error of the historical
mean. The sample period is from 1950 or 1960 through 2007. Forecasts begin 20 years after the sample start. Asterisks denote signicance of the insample regression as measured by the F-statistic or signicance of the out-of-sample MSEF statistic of McCracken (2007). nnn, nn, and n denote
signicance at the 1%, 5%, and 10% level respectively.
Out-of-sample R-square
Variable
Forecast
start
Description
In-sample
R-square
Predictive
regression
Predictive
regression
(shrinkage)
SOP
no multiple
growth
SOP
multiple growth
regression
SOP
multiple
reversion
LTY
Long-term bond yield
TMS
Term spread
TBL
T-bill rate
DY
Dividend yield
Constant
1970
1970
1970
1970
1970
1970
5.29n
3.10
1.47
11.97nnn
47.54
14.71
20.87
9.19
5.61
1.13
3.07
5.07nn
10.73nnn
4.16nn
9.26nn
6.39nn
13.28nnn
11.27nnn
11.60nnn
11.51nnn
10.78nnn
11.75nnn
LTY
Long-term bond yield
TMS
Term spread
TBL
T-bill rate
DY
Dividend yield
Constant
1970
1970
1980
1980
1970
1970
1.69
0.36
1.76
15.24nnn
11.01
5.46
7.57
3.12n
1.86
0.89
0.62
6.63nn
12.14nnn
12.11nnn
5.75nn
5.14n
10.25nnn
11.87nnn
5.82nn
5.62nn
11.99nnn
11.91nnn
LTY
Long-term bond yield
TMS
Term spread
TBL
T-bill rate
DY
Dividend yield
Constant
1970
1970
1970
1970
1970
1970
0.17
1.11
0.03
7.95nn
20.73
12.05
21.18
0.96
1.51
0.99
2.00
2.68n
7.75nn
4.47nn
8.24nn
5.06nn
6.64nn
3.12n
5.50nn
3.40n
5.73nn
5.92nn
17.5
UK
Japan
US
15.0
12.5
10.0
7.5
5.0
2.5
0.0
1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007
Fig. 7. Sum-of-the-parts (SOP) method forecast of international stock market returns. The gure shows annual forecast of market return in the UK, Japan,
and the US from the SOP method with no multiple growth.
30
533
Table 8
Forecasts of stock market returns: analyst earnings forecasts
This table presents in-sample and out-of-sample R-squares (in percentage) for stock market return forecasts at monthly frequency from predictive
regressions and the sum-of-the-parts (SOP) method. The in-sample R-squares are estimated over the full-sample period. The out-of-sample R-squares
compare the forecast error of the model with the forecast error of the historical mean. The SOP method uses alternatively analyst earnings forecasts and
historical earnings to calculate gm and ge. The sample period is from January 1982 through December 2007. Forecasts begin ve years after the sample
start. Asterisks denote signicance of the in-sample regression as measured by the F-statistic or signicance of the out-of-sample MSEF statistic
of McCracken (2007). nnn, nn, and n denote signicance at the 1%, 5%, and 10% level respectively.
Out-of-sample R-square
SOPAnalyst forecasts
Variable
Description
In-sample
R-square
Predictive
Predictive regression
regression (shrinkage)
SVAR
Stock variance
0.88
2.97
0.17
DFR
Default return
0.60
2.20
0.14
spread
LTY
Long-term bond
0.26
0.67
0.02
yield
LTR
Long-term bond
0.26
0.45
0.01
return
INFL
Ination
0.04
0.76
0.06
TMS
Term spread
0.01
2.00
0.15
TBL
T-bill rate
0.29
1.18
0.03
DFY
Default yield spread 0.51
0.49
0.04
NTIS
Net equity
0.66
1.23
0.06
expansion
ROE
Return on equity
0.02
1.84
0.10
DE
Dividend payout
0.02
1.79
0.12
nnn
nnn
EP
Earnings price
2.68
1.78
0.56n
nn
SEP
Smooth earnings
1.25
0.22
0.19
price
0.00
0.29n
DP
Dividend price
1.74nn
DY
Dividend yield
1.74nn
0.23
0.28n
BM
Book-to-market
1.02n
0.14
0.14
Constant
No
multiple
growth
Multiple
reversion
No
multiple
growth
Multiple
growth
regression
Multiple
reversion
2.32nnn
2.26nnn
2.20nnn
2.15nnn
2.19nnn
3.62nnn
2.81nnn
3.51nnn
3.59nnn
3.62nnn
2.25nnn
3.10nnn
3.52nnn
4.66nnn
2.26nnn
2.17nnn
3.60nnn
3.58nnn
2.22nnn
2.15nnn
2.19nnn
2.12nnn
2.01nnn
2.13nnn
2.07nnn
2.60nnn
2.31nnn
2.37nnn
3.54nnn
3.22nnn
3.37nnn
3.34nnn
2.97nnn
3.62nnn
3.59nnn
4.23nnn
3.50nnn
3.62nnn
1.97nnn
2.26nnn
2.39nnn
2.13nnn
2.23nnn
1.70nnn
3.17nnn
3.59nnn
3.61nnn
3.39nnn
3.54nnn
3.13nnn
2.08nnn
2.07nnn
2.16nnn
2.17nnn
3.29nnn
3.25nnn
3.39nnn
3.61nnn
In each simulation of the economy, we replicate our outof-sample empirical analysis; that is, we compute for each
year the forecast of returns from the three approaches
(historical mean, predictive regression, and SOP method
with no multiple growth) using only past data. The regressions use the log dividendprice ratio as predictive variable.
Fig. 8 shows a scatter plot of each estimator of expected
returns versus the true expected returns at the end of the
simulated samples. The SOP expected return estimates have
the lowest bias and variance.19 The historical mean also
has a low variance, but it does not capture the variation in
the true expected returns. Predictive regressions have poor
performance in terms of predicting stock market returns,
with a higher variance than the SOP and historical mean
methods.
19
Multiple
growth
regression
SOPHistorical data
T 1
T 1
1 X
1 X
Em^ s ms 2
Varm^ s
Ts0 s s0
Ts0 s s0
T 1
T 1
1 X
1 X
Varms
2 Covm^ s , ms ,
Ts0 s s0
Ts0 s s0
31
534
Fig. 8. Monte Carlo simulation. The expected return estimates are plotted against true expected returns from a Monte Carlo simulation of the economy
in Binsbergen and Koijen (2010). The simulation generates ten thousand samples of 80 years of returns, dividend growth, and the dividendprice ratio for
this economy. In each simulation of the economy, annual expected returns are estimated with past data using the historical mean, predictive regression
with the log dividendprice ratio as conditioning variable, and the sum-of-the-parts (SOP) method with no multiple growth. The solid line is a 451 line.
where E, Var, and Cov are moments across simulations. The rst term corresponds to the square of the bias
of the estimates of expected returns. The second term
is the variance of the estimates of expected returns.
The third term is the variance of the true expected return
(which is the same for all methods). The nal term is the
covariance between the estimates of expected returns and
the true expected return. Panel B of Table 9 presents the
results of this decomposition of the MSE in the simulation
exercise.
While the bias squared component of all estimates of
expected returns is insignicant, the variance of the
predictive regression estimates of expected returns is
more than ve times larger than the variance of the SOP
estimates. This variance, due to estimation error, is therefore the main weakness of predictive regressions. The
historical mean estimates of expected returns present a
variance slightly lower than the SOP estimates. Regarding
the covariance term, the SOP and predictive regressions
estimates of expected return have signicant positive
correlations with the true expected return, which contribute to reducing the MSE. In contrast, the historical
mean is negatively correlated with the true expected
return, which adds to its MSE. Overall, the superior
performance of the SOP method relative to the predictive
regression comes from its lower variance and its higher
correlation with the true expected return. The superior
performance of the SOP method relative to the historical
535
Table 9
Monte Carlo simulation: mean square error of return forecasts.
This table presents the results of a Monte Carlo simulation of the economy in Binsbergen and Koijen (2010). The simulation generates ten thousand
samples of 80 years of returns, dividend growth, and the dividendprice ratio for this economy. In each simulation of the economy, annual forecast of
returns are estimated, alternatively, under the historical mean, predictive regression with the log dividendprice ratio as conditioning variable, and sumof-the-parts (SOP) with no multiple growth methods using only past data. The forecast errors are given by the difference between the return forecasts
and the true expected returns from the simulation. Panel A reports the mean, median, and other percentiles (across simulations) of the root mean square
errors (RMSE) of each method. Panel B reports each component of the mean square errors (MSE) decomposition. Bias square of estimator is given by
P
PT1
2
^
^
1=Ts0 T1
s s0 Em s ms . Variance of estimator is given by 1=Ts0
s s0 Varm s . Variance of true expected returns is given by
PT1
P
^
1=Ts0 s s0 Varms . Covariance of estimator and true expected returns is given by 1=Ts0 T1
s s0 Covm s , ms .
Historical
mean
Predictive
regression
SOP with no
multiple growth
4.94
3.22
3.85
4.72
5.77
6.95
3.73
2.04
2.62
3.48
4.58
5.78
2.87
1.90
2.23
2.71
3.32
4.05
0.244
0.264
1.951
0.200
2.658
0.017
2.697
1.951
3.055
1.608
0.007
0.511
1.951
1.567
0.902
varying risk premium, the success of our analysis eventually destroys its usefulness. Once enough investors
follow our approach to predict returns, they will impact
market prices and again make returns unpredictable.
5. Conclusion
and
b
s ^
b
s i
32
a r s b x s ,
where x s is the historical mean of the predictor up to time
s. In this way, the slope coefcient is shrunk toward zero,
and the intercept changes to preserve the unconditional
mean return. The shrinkage intensity i can be thought of
as the weight given to the prior of no predictability. It is
measured in units of time periods. Thus, if i is set equal to
the number of data periods in the data set s, the slope
coefcient is reduced by half. Connor (1997) shows that it
is optimal to choose i 1=r, where r is the expectation of
a function of the regression R-square:
2
R
rE
33
ER2 :
1R2
This is the expected explanatory power of the model. We
use i =100 with yearly data and i=1,200 with monthly
data. This would give a weight of one hundred years of
data to the prior of no predictability. Alternatively, we can
interpret this as an expected R-square of approximately
1% for predictive regressions with yearly data and less
than 0.1% with monthly data, which seems reasonable in
536
m^ s a b xs :
34
b
s ^
b
si
35
and
a b x s ,
36
37
c d u^ s ,
38
c d u^ s ,
39
d
and
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