Do Decomposed Financial Ratios Predict Stock Returns and Fundamentals Better?

Abstract

We investigate the prediction of excess returns and fundamentals by financial ratios – dividend-price ratio, earnings-price ratio, and book-to-market ratio – by decomposing financial ratios into a cyclical component and a stochastic trend component. We find both components predict excess returns and fundamentals. The cyclical components predict increases in future stock returns, while the stochastic trend components predict declines in future stock returns, in particular, in long horizons. This helps explain previous findings that financial ratios in the absence of decomposition find weak predictive power in short horizons and some predictive power in long horizons. We also find both components predict fundamentals, consistent with present value models.