Predicting the Equity Premium with Dividend Ratios: Reconciling the Evidence

33 Pages Posted: 19 Feb 2009 Last revised: 4 Nov 2014

See all articles by Neil Kellard

Neil Kellard

University of Essex - Essex Business School

John C. Nankervis

University of Essex - Department of Accounting, Finance & Management

Fotios I. Papadimitriou

Business School, University of Aberdeen

Date Written: November 12, 2008

Abstract

This paper evaluates the ability of dividend ratios to predict the equity premium. We conduct an out-of-sample comparative study and apply the Goyal and Welch (2003) methodology to equity premia derived from the UK FTSE All-Share and the S&P 500 indices. Preliminary in-sample univariate regressions reveal that in both markets the equity premium contains an element of predictability. However, out-of-sample the considered models outperform the historical moving average only in the UK context. This is confirmed by the graphical diagnostic which further indicates that dividend ratios are useful predictors of UK excess returns. Our paper provides a possible explanation of why dividend ratios might be more informative in the UK market and links these findings to a phenomenon that is not widely known in the predictability literature. Finally, Campbell and Shiller (1988b) identities are employed to account for the time-varying properties of the dividend ratio and dividend growth processes. It is shown that by instrumenting the models with the identities, forecasting ability can be further improved.

Keywords: Equity Premium, Stock Return Predictability, Dividend Ratios, Out-of-Sample Prediction

JEL Classification: C22, C32, C53

Suggested Citation

Kellard, Neil and Nankervis, John C. and Papadimitriou, Fotios I., Predicting the Equity Premium with Dividend Ratios: Reconciling the Evidence (November 12, 2008). A revised version appears in the Journal of Empirical Finance, Vol. 17, No. 4, 2010, Available at SSRN: https://ssrn.com/abstract=1344309 or http://dx.doi.org/10.2139/ssrn.1344309

Neil Kellard (Contact Author)

University of Essex - Essex Business School ( email )

Wivenhoe Park
Colchester CO4 3SQ
United Kingdom
+44-1206-87-4153 (Phone)

John C. Nankervis

University of Essex - Department of Accounting, Finance & Management ( email )

Wivenhoe Park
Colchester CO4 3SQ
United Kingdom

Fotios I. Papadimitriou

Business School, University of Aberdeen ( email )

Dunbar Street
Aberdeen, Scotland AB24 3QY
United Kingdom

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