Price Dividend Ratio and Long-Run Stock Returns: A Score Driven State Space Model

Abstract

In this paper we develop a general framework to analyze state space models with time-varying system matrices where time variation is driven by the score of the conditional likelihood. We derive a new filter that allows for the simultaneous estimation of the state vector and of the time-varying parameters. We use this method to study the time-varying relationship between the price dividend ratio, expected stock returns and expected dividend growth in the US since 1880. We find a significant increase in the long-run equilibrium value of the price dividend ratio over time, associated with a fall in the long-run expected rate of return on stocks. The latter can be attributed mainly to a decrease in the natural rate of interest, as the long-run risk premium has only slightly fallen.

Keywords: equity premium, present-value models., score-driven models, state space models, time-varying parameters

JEL Classification: C22, C32, C51, C53, E31