Financial Ratios, Expected Returns, and Fundamentals

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 dominate the predictive power at short horizons, whereas the stochastic trend components dominate the predictive power at long horizons. We find that the predictability is due to three channels: local mean reversion, slow mean reversion, and momentum of financial ratios.