Expected Returns and Expected Dividend Growth

Abstract

We investigate a consumption-based present value relation that is a function of future dividend growth. Using data on aggregate consumption and measures of the dividend payments from aggregate wealth, we show that changing forecasts of dividend growth are an important feature of the post-war U.S. stock market, despite the failure of the dividend-price ratio to uncover such variation. In addition, these dividend forecasts are found to covary with changing forecasts of excess stock returns. The variation in expected dividend growth we uncover is positively correlated with changing forecasts of excess returns and occurs at business cycle frequencies, those ranging from one to six years. This covariation is important because positively correlated fluctuations in expected dividend growth and expected returns have offsetting affects on the log dividend-price ratio. The results therefore imply that both the market risk-premium and expected dividend growth vary considerably more than what can be revealed using the log dividend-price ratio alone as a predictive variable.

Keywords: Risk premia, dividend growth, cash-flow predictability, return predictability