The Predictability of Returns with Regime Shifts in Consumption and Dividend Growth
39 Pages Posted: 16 Mar 2010
Date Written: January 10, 2010
The puzzle that the market-wide price-dividend ratio predicts neither the market return nor dividend growth in linear regressions is addressed in an equilibrium model with two regimes where the process of the conditional mean of dividend growth is more predictable in one regime than in the other. The consumer observes x_t that is approximately the conditional mean of the aggregate consumption growth rate and also calculates the posterior probability, p_t, that the economy is in the first regime. In linear predictive regressions over 1930-2006, the price-dividend ratio predicts the market return but not dividend growth if p_t > 0.5; and it predicts dividend growth but not the market return if p_t < 0.5. Furthermore, in linear predictive regressions, the state variables (x_t, p_t) and their product perform significantly better at predicting the equity premium, size premium, value premium, consumption growth, and dividend growth over 1930-2006, than linear regressions with predictive variables the price-dividend ratio and risk free rate.
Keywords: Return Predictability, Consumption Growth Predictability, Dividend Growth Predictability, Regime Shifts, Cross-Section of Returns
JEL Classification: G12, E44
Suggested Citation: Suggested Citation