Return predictability with endogenous growth
69 Pages Posted: 14 Oct 2018 Last revised: 23 Nov 2022
Date Written: November 17, 2018
The component of the volatility of total factor productivity (TFP) that is orthogonal to the dividend price ratio is shown to have long-run predictive ability for market returns. This finding implies that TFP volatility should also predict real cash flows and/or real interest rates: it is found to mainly predict real cash flows through inflation. A model with endogenous growth, Epstein-Zin preferences and price rigidities reconciles both TFP volatility-driven long-run pre- dictability and its real implications. Within the model, we justify the cross-sectional pricing of TFP volatility risk in alternative asset classes as well as the similar (to that of TFP volatility) predictive ability of a suitable low-frequency notion of market volatility.
Keywords: uncertainty trends, valuation ratios, endogenous growth, price rigidities, financial uncertainty
JEL Classification: C22, E32, E44, G12, G17
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