Predicting the Equity Premium with Dividend Ratios

Our paper suggests a simple, recursive residuals (out-of-sample) graphical approach to evaluating the predictive power of popular equity premium and stock market timeseries forecasting regressions. When applied, we find that dividend ratios should have been known to have no predictive ability even prior to the 1990s, and that any seeming ability even then was driven by only two years, 1973 and 1974. Our paper also documents changes in the time-series processes of the dividends themselves and shows that an increasing persistence of dividend-price ratio is largely responsible for the inability of dividend ratios to predict equity premia. Cochrane’s (1997) accounting identity—that dividend ratios have to predict long-run dividend growth or stock returns—empirically holds only over horizons longer than 5–10 years. Over shorter horizons, dividend yields primarily forecast themselves. (Equity Premium; Stock Returns; Dividend Yield; Out-of-Sample Prediction)