Predicting the equity premium with financial ratios: A comprehensive look over a long period in Korea

Abstract

This study investigates whether financial ratios, such as the dividend-price, price-to-book, or price-earnings ratios, reliably predict the equity premium in Korea. We construct the longest possible time series data for the stock market index excess returns including dividends and associated financial ratios by collecting data from various sources including data only available in hard copy publications from 1968 to 2021. We also construct the cyclically adjusted price-earnings (CAPE) ratio as a predictor which has not been used in previous studies on the Korean stock market. We estimate the predictive regressions using the IVX method, which is robust to having a persistent independent variable and overlapping data as a dependent variable and can accommodate multiple independent variables. We also assess the economic gains of the predictability by examining the certainty equivalent return for a mean-variance investor. We find that the CAPE ratio reliably predicts the equity premium for horizons ranging from one month to two years, and the results survive various robustness tests.