Fundamental Extrapolation and Stock Returns

Abstract

We study fundamental extrapolation based on multiple fundamental variables. Using ten leading such variables, we find that they have much stronger predictive power on stock returns than previously thought, via three pooling strategies that integrate information simultaneously. They outperform naive extrapolations using a single fundamental variable and strategies using past prices or analyst forecasts. We propose a simple equilibrium model to explain the predictability, which allows for both a cash flow effect, which pushes stock price up relative to the fundamental value, and a discount rate effect, which depresses stock price with an increased exposure on the consumption volatility.

Keywords: Fundamental Extrapolation; Return Extrapolation; Volatility; Expectation

JEL Classification: G41, G14