Abstract
Motivated by the residual income valuation model of Ohlson (1995), we introduce a new approach to forecasting market returns that combines the cross-section of dividends, earnings, and book values to explain current stock prices and extract aggregate expected returns. Our measure of market return expectations is strongly correlated with popular ex ante equity premium measures and business cycle variables. It portends a significant fraction of the time-series variation in stock market returns at horizons of one month to two years. Consistent with the theory on which our measure is based, the predictability that we uncover is particularly strong at longer return forecasting horizons, where it dominates that afforded by popular predictive variables, achieving an out-of-sample R2 of 12.6% at the annual horizon.
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