The Predictability of Returns with Regime Shifts in Consumption and Dividend Growth
45 Pages Posted: 19 Mar 2011
Date Written: March 15, 2011
The predictability of the market return and dividend and consumption 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 market-wide 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 in-sample and out-of-sample prediction of the equity, size, and value premia, aggregate consumption and dividend growth rates, and variance of market return than linear regressions with the 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
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