Explaining Returns with Cash-Flow Proxies
44 Pages Posted: 30 Mar 2005 Last revised: 10 Jul 2010
Date Written: March 2005
Stock returns are correlated with contemporaneous earnings growth, dividend growth, future real activity, and other cash-flow proxies. The correlation between cash-flow proxies and stock returns may arise from association of cash-flow proxies with one-period expected returns, cash-flow news, and/or expected-return news. We use Campbell's (1991) return decomposition to measure the relative importance of these three effects in regressions of returns on cash-flow proxies. In some of the popular specifications, variables that are motivated as proxies for cash-flow news also track a nontrivial proportion of one-period expected returns and expected-return news. As a result, the R2 from a regression of returns on cash-flow proxies may overstate or understate the importance of cash-flow news as a source of return variance.
Suggested Citation: Suggested Citation