Expected returns and expected dividend growth: time to rethink an established empirical literature

Abstract

This article examines various state-space and VAR model specifications to investigate the contributions of expected returns and expected dividend growth to movements in the price-dividend ratio. We show that both models involve serious inference problems that need to be dealt with carefully. We propose procedures that offer more reliable inference results, and the corrected inferences indicate that the aggregate data of dividends and returns alone do not provide strong enough evidence to support the notion that the expected returns dominate the stock price variation. However, we show that an alternative measure of cash flows termed the net payout by Larrain and Yogo (2008) appears to lend strong support to the notion that the expected cash flow explains a large fraction of the firm value variation. This finding remains robust in both state-space and VAR decompositions with the corrected inference.

Keywords:

• stock price decomposition
• state-space model
• weak identification

JEL Classification:

• G12
• C32
• C58

Notes

¹ Balke and Wohar (2002) find the more general result that the factor with the largest degree of persistence is the factor that contributes most to movements in the price-dividend ratio.

² The methodology in this section draws heavily from Ma and Wohar (2014).

³ Hansen, Heaton and Li’s data sources and procedures to compute return and dividend series are available on Nan Li’s website: http://www.bschool.nus.edu.sg/staff/biznl/ . Note that this way of backing out and aggregating dividends is different from the way in Ma and Wohar (2013) that backs out the annual dividends directly from the annual returns as in Cochrane (2011).

⁴ We also estimate the model using quarterly data and obtain similar results. These results are available upon request.

⁵ We focus on the estimation of the cash-reinvestment dividends model since the market-reinvestment dividends model yields similar variance decomposition of the price-dividend variation.

⁶ We also estimate most of our models using the longer sample period starting from the year 1927. Except for some notable differences of some correlation estimates, the major result that the returns contribution dominates remains the same. These results are available upon request.

⁷ We also did the same exercise using the long span data of 1927–2011, and our major conclusion stays the same. These results are available upon request.

⁸ We also follow Campbell (1991) and implement a bootstrap procedure by setting the price-dividend ratio to follow a unit root process under the null. The resulting coverage of confidence intervals all becomes even wider, making it harder to reject the null hypothesis, lending further support to our major findings. These results are available upon request.

⁹ This data set is available on Robert Shiller’s website: http://www.econ.yale.edu/~shiller/data.htm

¹⁰ We thank Yogo for generously providing their data set.

¹¹ We find that the model fails to converge for the identification restriction .