Predicting Market Returns Using Aggregate Implied Cost of Capital

Abstract

Theoretically, the implied cost of capital (ICC) is a good proxy for time-varying expected returns. We find that aggregate ICC strongly predicts future excess market returns at horizons ranging from one month to four years. This predictive power persists even in the presence of popular valuation ratios and business cycle variables, both in-sample and out-of-sample, and is robust to alternative implementations. We also find that ICCs of size and B/M portfolios predict corresponding portfolio returns.

Keywords: Implied Cost of Capital, Market Predictability, Valuation Ratios

JEL Classification: G12