Re-examining the Higher Predictive Power of D/P and E/P during Recessions

Frederick Adjei

doi:10.12691/jfe-7-1-4

Abstract

In this study, we examine the differential predictive power of the dividend-price ratio [D/P] and the earnings-price ratio [E/P] for future stock returns during recessions versus during expansionary periods. We find that dividends do not decrease but prices decrease from the expansion periods to the recession periods resulting in the D/P increase during recessions. This increase in D/P during recessions is correlated with the increase in market returns following recessions. However, we find no significant difference in means of E/P between recession and expansion periods. Additionally, we find that the explanatory power of D/P and E/P for future market returns varies with time. D/P, E/P, and future market returns move together during the first two subperiods, peaking toward the end of recession periods. Particularly, D/P and future market return trend differently during expansion periods, but the trends are reset into tandem during recession periods, also explain why predictive regressions in studies using the full sample period present conflicting results.

Highlights

Extant research such as Rapach, Strauss, and Zhou [1] and Dangl and Halling [2] document that excess stock return predictability by the dividend-price ratio [D/P] and the earnings-price ratio [E/P] concentrates mostly in recessions; such valuation ratios have higher predictive power during recessions
For the third subperiod of our sample period: January, 1986 to December, 2016, earnings as well as prices decrease from the expansion periods to the recession periods resulting in the E/P decrease
E/P is significantly lower during the recession periods; earnings decrease and prices decrease from the expansion periods to the recession periods resulting in the E/P decrease

Summary

Introduction

Extant research such as Rapach, Strauss, and Zhou [1] and Dangl and Halling [2] document that excess stock return predictability by the dividend-price ratio [D/P] and the earnings-price ratio [E/P] concentrates mostly in recessions; such valuation ratios have higher predictive power during recessions. We demonstrate and document that the higher predictive power of recession period D/P and E/P for future stock returns can be explained by a far more elemental phenomenon; the nature of the computation of the D/P and E/P ratios. We document that dividends do not decrease but prices decrease from the expansion periods to the recession periods resulting in the D/P increase during recessions This increase in D/P during recessions is correlated with the increase in market returns following recessions and explains the documented predictive power of D/P for future returns. The trends in D/P and E/P: the decrease in dividends relative to prices, and the decrease in E/P during recessions in the last 31 years [1986 to 2016], explain the differential predictive powers and explain why predictive regressions in studies using the full sample period present conflicting results

Literature Review

Hypothesis Development

Data and Descriptive Statistics

Findings

Conclusion