Predicting stock returns with implied cost of capital: A partial least squares approach

Abstract

We extract a single factor from popular aggregate implied cost of capital (ICC) measures using partial least squares method. This combined measure strongly predicts future stock market returns, both in-sample and out-of-sample. The predictive power outperforms and complements those of individual ICCs, other combined ICC approaches, as well as macroeconomic and sentiment variables. Cross-sectionally, it strongly predicts various equity portfolio returns, particularly large-size portfolios and portfolios with lower accruals and earnings volatility. The predictive power extends to bond portfolios and monotonically increases with maturities. The results suggest that the combined ICC tracks time-varying discount rate through the macroeconomic uncertainty channel.