Equity Duration and Predictability

Abstract

One of the most puzzling findings in asset pricing is that expected returns dominate the variation in equity price movements, leaving little room for expected dividends to have an impact. Even more puzzling is that this dominance only emerged after 1945. We argue that an increase in equity duration can explain these findings. We provide empirical support across three datasets: dividend strips, the long time series for the market, and the cross-section of stocks. We develop and calibrate a simple present value model that incorporates the effect of duration. Around 50% of the duration effect comes from expected returns being more persistent than dividend growth rates; 46% comes from the variance of shocks to expected returns increasing with duration, and the remaining 4% is due to the interaction between both effects.

Keywords: Duration, return predictability, dividend growth predictability, historical data, dividend strips

JEL Classification: G12, G17, N2