Predicting equity premium with adjusted dividend-price ratio: the USA and international evidence

Abstract

Purpose This paper aims to achieve two main objectives. The first is to introduce a suitable adjustment to the conventional dividend-price ratio, which would address econometric concerns and improve the predictability of the equity premium. The second is to compare the predictive performance of the newly introduced adjusted dividend-price ratio with the conventional dividend-price ratio. Design/methodology/approach The authors hypothesize that the adjusted dividend-price ratio will have better predictive power and forecasting quality for equity premium compared to the conventional dividend-price ratio. To test the hypothesis, the authors predict equity premium with both variables on a sample of 11 developed and emerging market indexes over a period spanning June 1995 to March 2017. To accommodate time variation in parameter values or structural breaks in the data, the authors conducted a fixed window rolling regressions using both variables. A variety of forecast techniques including magnitude and sign accuracy measures are applied to compare the performance of forecasts. Findings The adjusted dividend-price ratio is shown to be stationary and has both lower persistence and variability compared with the conventional dividend-price ratio. The authors find that the adjusted dividend-price ratio provides superior out-of-sample (OOS) performance compared to the conventional dividend-price ratio, for both size and sign accuracy, in forecasting equity premium for the majority of the countries in the sample. Research limitations/implications This paper introduces an easy-to-follow modification in the conventional dividend-price ratio that can be replicated by researchers and practitioners alike. However, the study has a limitation in that it does not capture the impact of dividend-paying firms within each index on the predictive ability of the adjusted dividend-price ratio. Practical implications The knowledge of equity premium predictability is important in implementing market-timing strategies and could be beneficial for portfolio and risk management. The newly introduced variable is easy to construct using widely available data without the need for complex econometric estimation. Investors can use this variable to predict equity premiums in international markets, both developed and emerging. The findings of this paper will be relevant to financial analysts, portfolio managers, investors and researchers in international finance. For example, by using the adjusted dividend-price ratio, investors would see up to 0.5% improvement in their OOS monthly forecasts of the equity premium. Originality/value To the best of the authors’ knowledge, this is the first paper that proposes adjustment in the conventional dividend-price ratio based on the past observations of the most recent quarter. In this way, the paper offers fresh insight that dividend-price ratio is still useful to predict equity premium albeit, after some adjustments and modifications. The findings of the paper would result in renewed interest in using the dividend-price ratio as a predictor of the equity premium.