Dividend Variability and Stock Market Swings

This paper examines the extent to which swings in stock prices can be related to variations in the discounted value of expected future dividends when investors face uncertainty about their future behavior. I develop an econometric model that accounts for the instability of U.S. dividend growth and discount rates during the past 120 years. Estimates of the model reveal that changing forecasts of future dividend growth account for more than 90% of the predictable variations in dividend-prices. The estimates also imply that instability in the dividend and discount rate processes contribute signiÞcantly to the predictability of long-horizon stock returns. ∗I would like thank the referees and The Foreign Editor, John Cochrane for many helpful suggestions. The paper has also beneÞtted from the comments of seminar participants at The Universities of Bristol, Exeter, Liverpool, and York, The London School of Economics, The Wharton School, The Federal Reserve Bank of Philadelphia, and the 1995 meetings of the Econometric Society. The research was completed while visiting the The Financial Markets Group at The London School of Economics and The Bank of England. I also gratefully acknowledge the Þnancial support of the Houblon-Norman Fund at The Bank of England.