An Alternative Model of Expected Returns and its Implications for Return Predictability

68 Pages Posted: 25 May 2014 Last revised: 29 Oct 2016

See all articles by Maxime Bonelli

Maxime Bonelli

HEC Paris - Finance Department

Daniel Mantilla-Garcia

Universidad de Los Andes - School of Management; EDHEC Risk Institute

Date Written: October 26, 2016

Abstract

Empirical studies have found that during bad times return predictability is higher. Thus, variation in discount rate news should be relatively higher as economic conditions worsen. We propose a parsimonious model for expected returns that captures the countercyclical dynamics of stock return predictability. The implications of the model are studied within a flexible Bayesian predictive system. In our empirical tests, the estimates from the proposed model of expected return present lower prediction errors than the historical mean, and than the predictive regression using the dividend yield. Furthermore, the persistence parameter of expected returns presents long-term dynamics similar to the autocorrelation of realized returns.

Keywords: return predictability, economic constraints, dividend-price ratio, Kalman filter, Bayesian analysis

JEL Classification: C58, G00, G17, C11

Suggested Citation

Bonelli, Maxime and Mantilla-Garcia, Daniel, An Alternative Model of Expected Returns and its Implications for Return Predictability (October 26, 2016). Available at SSRN: https://ssrn.com/abstract=2441323 or http://dx.doi.org/10.2139/ssrn.2441323

Maxime Bonelli

HEC Paris - Finance Department ( email )

France

Daniel Mantilla-Garcia (Contact Author)

Universidad de Los Andes - School of Management ( email )

Bogota, Bogota D.C.
Colombia

EDHEC Risk Institute ( email )

Lille
France

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