Stock Return Predictability and Cyclical Movements in Valuation Ratios

Abstract

According to present-value models, a financial valuation ratio should predict future stock returns or cash flows; however, when testing empirically, this ratio shows little power. This paper develops insights about stock return predictability and reconciles the contradicting findings about the information provided by financial ratios. We decompose the financial ratio into a slow-moving component which reflects the local time-varying expected values of the financial ratio, and a cyclical component which reflects the transitory movements of the ratio toward its local time-varying mean. The cyclical components of financial ratios deliver substantially improved out-of-sample forecast gains of stock returns and/or cash flows, relative to the original financial ratios and the historical average benchmark, both in- and out-of-sample. Conversely, the slow-moving components fail to predict returns, and therefore disguises the predictive information contained in the dividend-price ratio for future returns.