Yale ICF Working Paper No.
04-02
December 16, 2003
A NOTE ON “PREDICTING RETURNS WITH
FINANCIAL RATIOS”
Amit Goyal
Emory University
Ivo Welch
Yale School of Management
This paper can be downloaded without charge from the
Social Science Research Network Electronic Paper Collection:
http://ssrn.com/abstract=486265
A Note on
“Predicting Returns with Financial Ratios”∗
Amit Goyal Ivo Welch
Goizueta Business School Yale School of Management
Emory University† Yale Economics Department
NBER‡
December 16, 2003
Abstract
This note reinterprets methods that seek to use the aggregate dividend price
ratio to predict aggregate stock market returns; specifically, methods which use
information about time-varying changes in the dividend-price ratio process to
improve the prediction equation. It argues that the empirical evidence is still
too weak to suggest practical usefulness of these estimators.
∗
We thank John Cochrane and Jonathan Lewellen for their detailed comments and suggestions.
†
http://www.goizueta.emory.edu/agoyal. E-mail: [email protected].
‡
http://welch.som.yale.edu. E-mail: [email protected].
In Predicting returns with financial ratios, Lewellen (2003) introduces a promising
new test to improve on the ability of financial ratios to predict stock returns. This test
relies on the fact that dividend yields are close to non-stationary, and have become
more so since 1973. The paper has received much attention, even before publica-
tion. (For example, Campbell and Yogo (2003) generalize the methodology.) A reader
not too familiar with the data would likely conclude that there is no question that
dividend yields can help investors predict stock returns, at least prior to 1995.
Yet, in Goyal and Welch (2003), we had also documented that dividend yields have
become more non-stationary over time, even indistinguishable from a random walk as
of December 2002. We then implemented a test statistic that directly uses Campbell
and Shiller’s (1988) identities to instrument not only the time-varying properties of
the dividend yield, but also the time-varying changes in the dividend growth process.
In contrast to Lewellen, we had concluded that neither the dividend yield, nor our
instrumented prediction could help investors predict the equity premium.
Predicting the equity premium may well be the most important issue in finance,
so it is important to reconcile the two perspectives. Both perspectives have evaluated
the same data through similar lenses (time-varying changes in the dividend process)
and still have come to opposite conclusions. This note explains why, and gives an
alternative perspective on the performance of Lewellen’s improved test.
Stambaugh (1999) introduces an underlying process of
rt = α + β·dpt−1 + r ,t (1)
dpt = µ + ρ·dpt−1 + dp,t , (2)
where r here is the simple1 stock return and dp is the log dividend price ratio. The
goal is to estimate the slope coefficient β in the return equation (1). The correlation
between r and dp violates the OLS assumption that the independent variable dpt−1
be uncorrelated with the errors r ,t . Therefore, the simple OLS estimate of β is up-
wardly biased. Denoting the estimator of β by β̂T and the estimator of ρ by ρ̂T , where
1
Using log-stock returns instead of simple returns does not matter at monthly frequency for our
results. We use the simple stock return to remain directly comparable with Lewellen (2003).
1
T is the number of observations, Stambaugh shows that the estimated beta should
be adjusted using the empirical estimate of ρ as follows:
adjusted cov(r , dp )
β̂T = β̂ols
T − × Estimated Bias in ρ̂T (3)
var(dp )
In Lewellen’s (and therefore our) full sample period, the OLS beta is about 0.009,
the covariance-variance ratio term is about –0.905, and the estimated rho is around
0.997. Stambaugh derives a frequentist correction for bias in ρ as −(1+3ρ̂T )/T . This
implies a bias in the prediction beta to be
cov(r , dp ) 1 + 3ρ̂T
Stambaugh ols
β̂T = β̂T + × . (4)
var(dp ) T
Therefore, Stambaugh reduces the OLS beta by roughly 3.6/T . With 660 observations,
this is about 0.0055.
Like the Stambaugh correction, the Lewellen estimator is also essentially an intel-
ligent shrinkage estimator, but it uses information about dividend process autocor-
relations in a different fashion. Lewellen rules out explosive bubbles, and therefore
estimates the bias in ρ as ρ̂T −0.9999. This implies that he can change the forecasting
beta to:
cov(r , dp )
β̂Lewellen
T = β̂ols
T + × [0.9999 − ρ̂T ] . (5)
var(dp )
Given the empirical estimates, Lewellen reduces the OLS beta by around 0.0025. Be-
cause the contemporaneous correlation between innovations is negative, and the esti-
mated ρ̂T is lower than 1, ρ̂T enters negatively in Stambaugh correction, but positively
in Lewellen correction. The higher Lewellen estimates ρ (closer to a random walk in
the dividend process), the more he shrinks the prediction beta towards the OLS beta.
Intuitively, with ρ̂T increasing in the sample period (1946–2000), and especially af-
ter 1995, Lewellen’s test can find evidence that the dividend yield can predict where
earlier papers had seemed to find only lack of significance. An interesting difference
between Stambaugh and Lewellen is that as T goes to infinity, Stambaugh suggests
zero shrinkage to the OLS beta, while Lewellen suggests a constant shrinkage.
Figure 1 plots both the betas and the dividend-price process autocorrelation. Lew-
ellen’s beta has the appealing feature that in the face of drastically changing dividend
process autocorrelation, the recursive estimated out-of-sample beta remains remark-
ably stable, when compared to the Stambaugh or the OLS beta. But the figure also
2
shows that Lewellen’s betas are lower than other beta estimates for most of the sam-
ple period. Thus, when compared to these other betas, his evidence of stronger
predictability is based on statistical grounds (lower estimation standard errors of his
beta), and not on economic grounds (higher beta estimates).
Cochrane (2001, p. 406) suggests that an intuitive way of looking at the betas
from an annual regression of returns on (simple) dividend price ratio. Because the
mean dividend price ratio for our sample period is 3.80%, this can roughly be ac-
complished by multiplying all our beta numbers by 12/3.80% ≈ 316. This gives the
OLS, Stambaugh, and Lewellen betas as 2.89, 1.16, and 2.09, respectively.2 Cochrane
argues that the benchmark beta for no predictability (when dividend price ratios are
random walks) is 1.0, and that for complete predictability (when dividend price ratios
are not persistent at all) is 25.0. Therefore, Stambaugh betas imply least predictability
and OLS betas imply the most predictability.
In Goyal and Welch, we relied directly on Campbell and Shiller’s (1988) identity to
derive
ols
β̂GW
T = 1 − κ·ρ̂T + β̂∆Div , (6)
where κ is 1/(1 + edp ), which can be calibrated to about 0.9968 with U.S. monthly
data, and β̂ols
∆Div is the slope coefficient in an OLS regression of (log) dividend growth
on dividend price ratio.3 The higher autocorrelation ρ̂T can also reduce the estimated
beta coefficient. This specification is consistent with Cochrane (2001, p. 402), who
states that “To believe in lower predictability of returns, you must either believe
that dividend growth really is predictable, or that the d/p ratio is really much more
persistent than it appears to be.” On theoretical grounds, our instrumentation is
most appealing, because it takes both sources into account.
Table 1 compares the empirical performances of these methods, keeping Lew-
ellen’s sample period (1946–2000 and 1946–1995), data frequency (monthly), and
specific data (value-weighted NYSE stock returns). The left columns of the table de-
2
Actual annual regressions of returns on simple dividend price ratios give OLS, Stambaugh, and
Lewellen betas as 1.12, 0.02, and 0.32 respectively.
3
Strictly speaking, identity (6) is valid only for log returns and dividend price ratio computed
using monthly dividends. As explained later, we use simple returns to be consistent with Lewellen
(2003). We also follow the standard practice to compute the dividend price ratio using the last 12-
month dividends but divide the mean dividend price ratio by 12 in parameter κ to make it consistent
with monthly frequency (1/(1 + d/p/12) ≈ 0.9968, where d/p is the twelve-month moving average
un-log-ed dividend price ratio.). Goyal-Welch (2003) use annual data where both of these concerns
are not an issue.
3
scribe in-sample residuals. The historical mean error is the first data row—naturally
zero for all methods used here. More interestinglly, if used for one-month ahead pre-
diction, the prevailing mean would have yielded an RMSE of 4.07% and an absolute
forecast error of 3.14%. The naïve OLS technique does a tiny bit better than the his-
torical mean.4 All modification (Stambaugh, Lewellen, and Goyal-Welch) techniques
have about the same performance as the OLS forecast. If we end the sample in 1995,
OLS, Goyal-Welch, Stambaugh, and Lewellen can all significantly outperform the his-
torical mean in-sample. If we end the sample in 2000, however, OLS, Goyal-Welch,
and Lewellen perform a little better than Stambaugh’s estimator.
The right columns of Table 1 describe out-of-sample performance. When we end
the sample in December 2000, Lewellen’s technique performs best on the RMSE met-
ric, where it can outperform the historical mean’s RMSE by 0.008% per month. This
is neither economically significant, even if aggregated to one year, nor statistically
significant in a Diebold and Mariano (1995) t-test on the RMSE difference (t = 0.65).5
OLS and Stambaugh perform 0.013% per month worse than Lewellen’s method. On
the MAE metric, the prevailing mean outperforms all dividend ratio techniques (and
sometimes in a statistically significant fashion). Our final metric is the frequency of
months in which a method beats the historical mean. Both Stambaugh and Lewellen
beat the historical mean 48.0% of the time, while OLS and GW beat it 47.4%. On all
metrics, despite its theoretical appeal, the instrumented Goyal-Welch procedure per-
forms no better than the naïve OLS beta. This is a reflection of the fact that there is
almost no difference between β̂ols GW
T and β̂T . Furthermore, it is not just the monthly
returns: in Goyal-Welch (2003), we explored annual forecasts, and found similarly
poor out-of-sample predictive ability.
If we end the sample in 1995 instead of 2000, it is the simple OLS predictor which
does best on the RMSE metric, followed closely by Lewellen’s and GW’s statistic. Be-
cause the Lewellen net performance is smoother than OLS’s (see Figure 1), on a RMSE
difference t-test, the Lewellen out-of-sample performance t-statistic reaches 1.81,
which corresponds to a two-tailed p-value of 0.071 and a one-tailed p-value of 0.036.
Although OLS and GW perform better than Lewellen’s test, their relative performance
4 2 2 2
This is a reflection of the low R . A low R should not be overinterpreted, because R of course
must be low in monthly regressions. However, in our earlier paper, we had used annual forecasts,
2
where in-sample R was more respectable (but not out-of-sample performance).
5
The Diebold and Mariano statistics’ properties are well known and well behaved. We had also
experimented with jackkniving these errors, and found virtually identical statistical significance.
4
advantage is not smooth enough to outperform the historical mean in a statistically
significant manner. Stambaugh’s method cannot significantly outperform, either. On
the MAE metric, the historical mean again performs best. On our final metric, Stam-
baugh and Lewellen can beat the historical mean 49.0% of the time, while OLS could
beat it only 48.3% of the time.6
Figure 2 repeats our favorite out-of-sample diagnostic from Goyal-Welch (2003).
We plot the cumulative out-of-sample (absolute or squared) forecast error of a method
minus the forecast error of the historical mean. When a line increases, the dividend-
yield method outpredicts the historical mean. When a line decreases, the historical
mean outpredicts the dividend-yield method. The figure shows that from about 1975
to 1994, by-and-large, the OLS/GW methods (virtually indistinguishable) performed
reasonably well on the RMSE metric, better than Lewellen, Stambaugh, and the histor-
ical mean. Ending the sample anywhere around 1990–1995 maximizes the relative
predictive ability of all dividend ratio methods. In 1995, Lewellen both beats OLS,
and has statistically superior performance relative to the historical mean. This is
because Lewellen’s technique is steadier, which gives it lower standard errors and
thus the aforementioned advantage in statistical significance. On the MAE metric,
no method seems to reliability outpredict the historical mean. OLS/GW significantly
underperform the mean until 1970. Beginning around 1994, all dividend techniques
underperform.
The most important metric may be the economic significance of these techniques.
Fortunately, both RMSE and MAE have intuitive magnitudes. A typical relative perfor-
mance advantage of a magnitude of around 0.01 percent per month is very modest.
If we use the trading strategy in Breen, Glosten, and Jagannathan (1989), we can de-
tect no gains to using any of these techniques. In our original paper, we used annual
returns and similarly failed to find economic relevance. For an investor, this level
of predictive ability, even if it were statistically better, is unlikely to be practically
useful.
In conclusion, the tests in Goyal-Welch (2003), Lewellen (2003), and Campbell and
Yogo (2003) incorporate changes in the dividend yield process in different ways into
6
Our Goyal-Welch estimator, while recognizing the economic sources of predictability, ignores
the statistical bias in computing the autocorrelation coefficient ρ̂T . If we use ρ̂T as 1.0 in equation (6)
instead of estimating it, Goyal-Welch estimator’s RMSE increases to 4.138% (from 4.134%) in sample
period ending 1995. Interestingly, however, on a RMSE difference t-test, the t-statistic reaches 1.95,
which corresponds to a two-tailed p-value of 0.051 and a one-tailed p-value of 0.025.
5
the prediction equation, but with only moderate success. Lewellen’s paper is a step in
the right direction, and can outperform the prevailing historical stock return mean
out-of-sample on at least one out-of-sample performance metric in a subperiod—
perhaps a first. But a reader of this literature should not be left with the impression
that it is unambiguously clear that predicting stock returns with these particular
dividend ratio methods would have yielded superior or even statistically significant
investment results. The data appear so ambiguous and perhaps uninformative that
a Bayesian investor might end up with a posterior that is very close to her priors—at
least on monthly and annual forecasting horizons. One reason to believe in dividend
price ratios to forecast returns or dividend growth is Cochrane’s well-known identity,
equation (7), which states that
∞
X
dpt = κ i (rt+1+i − ∆Divt+i+1 ) + constant (7)
i=0
= κ · dpt+1 + (rt+1 − ∆Divt+1 ). (8)
Because the dividend price ratio has not predicted dividend growth, one might believe
that it should predict stock returns. But, equation (8) points out why optimism may
be premature: the dividend price ratio has failed in the common empirical practice
which forecast stock returns on monthly or annual horizons, because the dividend
yield has not so much forecast either dividend growth or stock returns, but primarily
because it has forecast itself.
In sum, Lewellen’s careful statistical analysis of biases in estimating the autocor-
relation of dividend price ratio results in a lower predictive in-sample beta on returns,
which argues for lower economic predictability. The out-of-sample performance does
not convince us, either. Given the sum total of the evidence, the conclusion—as to
whether these dividend yield forecasting techniques for stock returns have succeeded
empirically—should, in our opinion, remain a matter of the reader’s evaluation of and
philosophy about empirical tests. Caveat Emptor.
6
References
Breen, William, Lawrence R. Glosten, and Ravi Jagannathan, 1989, “Economic Signif-
icance of Predictable Variations in Stock Index Returns," Journal of Finance 44(5),
1177–1189.
Campbell, John Y, and Motohiro Yogo, September 2003, “Efficient Tests of Stock Re-
turn Predictability,” Working Paper, Harvard University and NBER.
Campbell, John Y. and Robert Shiller, 1988, “The Dividend-Price Ratio and Expecta-
tions of Future Dividends and Discount Factors,” Review of Financial Studies 1(3),
195–228.
Cochrane, John H., 2001, Asset Pricing, Princeton University Press, Princeton.
Diebold, Francis X., and Roberto S. Mariano, 1995, “Comparing Predictive Accuracy,"
Journal of Business and Economics Statistics 13(3), 253-–263.
Goyal, Amit, and Ivo Welch, 2003, “Predicting the Equity Premium with Dividend
Ratios,” Management Science 49(5), 639–654.
Lewellen, Jonathan, August 2003, “Predicting Returns with Financial Ratios,” Journal
of Financial Economics, forthcoming.
Stambaugh, Robert, 1999, “Predictive Regressions,” Journal of Financial Economics
54(3), 375–421.
7
Table 1: Predictive Performance: Statistics on Forecast Errors
Forecasts Ending in 2000
In-Sample Out-of-Sample
2
Statistic Mean RMSE MAE R Mean SDV RMSE MAE Beats
Historical Mean 0.000% 4.072% 3.139% 0.000% -0.018% 4.164% 4.160% 3.170% Mean
OLS 0.000% 4.061% 3.134% 0.409% -0.348% 4.154% 4.165% 3.225% 256/540
Stambaugh 0.000% 4.065% 3.135% 0.208% -0.115% 4.168% 4.165% 3.197% 259/540
Lewellen 0.000% 4.062% 3.134% 0.366% -0.183% 4.152% 4.152% 3.186% 259/540
Goyal-Welch 0.000% 4.061% 3.134% 0.409% -0.334% 4.154% 4.164% 3.221% 256/540
Forecasts Ending in 1995
In-Sample Out-of-Sample
2
Statistic Mean RMSE MAE R Mean SDV RMSE MAE Beats
Historical Mean 0.000% 4.057% 3.119% 0.000% 0.026% 4.157% 4.152% 3.146% Mean
OLS 0.000% 4.027% 3.115% 1.312% -0.230% 4.131% 4.133% 3.182% 232/480
Stambaugh 0.000% 4.030% 3.110% 1.173% -0.022% 4.149% 4.145% 3.159% 235/480
Lewellen 0.000% 4.036% 3.110% 0.902% -0.090% 4.138% 4.134% 3.153% 235/480
Goyal-Welch 0.000% 4.027% 3.114% 1.310% -0.222% 4.132% 4.134% 3.180% 232/480
All models predict the value–weighted market rate of return, beginning in 1946. The first forecast
is predicted in 1956 to allow for 10 years to elapse before the first forecast is made. “Beats Mean”
is the number of months in which the absolute forecast error of a method is less than absolute
historical prevailing mean forecast error. Boldface means best performer.
8
Figure 1: Recursive Beta Coefficients and Time-Varying Dividend Price Ratio Pro-
cess
This figure plots the recursively computed betas from equation
rt = α + β·dpt−1 + r ,t ,
where r is the value-weighted NYSE return, and dp is the log dividend price ratio. Beta adjustments
are given by
cov(r , dp ) 1 + 3ρ̂T
Stambaugh
β̂T = β̂ols
T + ·
var(dp ) T
cov(r , dp )
β̂Lewellen
T = β̂ols
T + · [0.9999 − ρ̂T ]
var(dp )
β̂GW
T = 1 − κ·ρ̂T + β̂ols
∆Div .
where the autocorrelation is estimated from the equation
dpt = µ + ρ·dpt−1 + dp,t
Al estimates are computed recursively using the beginning date till all the data upto current period.
The overall sample period is 1945 to 2000. Goyal-Welch beta is virtually indinguishable from the
OLS beta and is not plotted separately.
Recursive Betas
0.04
βOLS
0.03 βStambaugh
βLewellen
0.02
0.01
−0.01
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
Recursive Autocorrelation
1
ρ
dp
0.99
0.98
0.97
0.96
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
9
Figure 2: Out-of-Sample Cumulative Performance Relative to the Historical Mean
This figure plots
T
X
Net-SSE(T ) = SE(t)Prevailing mean − SE(t)Dividend Model
t=1956
where SE(t) is either the squared or the absolute out-of-sample prediction error in period t. For a
month in which the slope is positive, the dividend ratio regression model predicted better than the
unconditional historical average out-of-sample. The vertical line is the end of 1995. The OLS and
GW estimates are virtually identical.
0.015
OLS (+GW)
Cumulative Outperformance Difference, RMSE
0.010
Lewellen
0.005
Stambaugh
Dividend Yield Method Predicts Better
0.000
Hist. Mean
Prevailing Mean Predicts Better
−0.005
1960 1970 1980 1990 2000
Month
0.05
Dividend Yield Method Predicts Better
0.00
Hist. Mean
Prevailing Mean Predicts Better
Cumulative Outperformance Difference, MAE
−0.05
Lewellen
−0.10
Stambaugh
−0.15
−0.20
−0.25
OLS (+GW)
−0.30
1960 1970 1980 1990 2000
Month
10
