Local predictability of stock returns and cash flows

Abstract

Motivated by the present-value framework, this article proposes a novel and flexible semiparametric long-horizon time-varying model to investigate the so-called ‘pockets of predictability’, which refer to local periods in which stock returns or cash flows are significantly predictable. A semiparametric profile method is used to estimate both time-varying and constant parameters. In the empirical studies, the predictive ability of the dividend-price ratio for dividend growth is considerably weaker than its ability to predict stock returns at both short and long horizons. Moreover, dividend smoothing only matters for dividend growth predictability at a low frequency. In addition, localized variance decomposition analysis suggests that the present-value relation is locally valid for most sample periods and that the main driver of the variation in the dividend-price ratio stems from its ability to predict stock returns. Lastly, using the earnings-price ratio produces similar results.