Decomposing the predictive power of local and global financial valuation ratios

Abstract

We examine the predictive power of global financial price-to-fundamental ratios for future stock returns in a panel of major developed countries. By disentangling global and local information, we find the global component to be at least equally important and that its importance has increased in recent decades. We further decompose the variability of valuation ratios into discount rate and cash flow driven components and find that the declining predictive power of local ratios coincides with a diminishing importance of the discount rate component. Our results underscore the relevance of global discount rate news in the time variation of local expected returns.