The Predictability of Returns with Regime Shifts in Consumption and Dividend Growth
42 Pages Posted: 6 Jul 2010 Last revised: 6 Sep 2012
Date Written: July 4, 2010
The predictability of the market return and dividend growth is addressed in an equilibrium model with two regimes. A state variable that drives the conditional means of the aggregate consumption and dividend growth rates follows different time-series processes in the two regimes. In linear predictive regressions over 1930-2009, the market return is predictable by the price-dividend ratio with R2 11.7% if the probability of being in the first regime exceeds 50%; and dividend growth is predictable by the price-dividend ratio with R2 28.3% if the probability of being in the second regime exceeds 50%. The model-implied state variables perform significantly better at predicting the equity, size, and value premia, the aggregate consumption and dividend growth rates, and the variance of market return than linear regressions with the market price-dividend ratio and risk free rate as predictive variables.
Keywords: Return Predictability, Consumption Growth Predictability, Dividend Growth Predictability, Regime Shifts, Cross-Section of Returns, Equity Premium, Size Premium, Value Premium
JEL Classification: G12, E44
Suggested Citation: Suggested Citation