Local Predictability of Stock Returns and Cash Flows

Motivated by the present-value framework, this article proposes a novel and flexible semiparametric time-varying model to examine the so-called `pockets of predictability,' i.e., stock returns or cash flows are significantly predictable in a given local period. We apply a semiparametric profile method to estimate both time-varying and constant parameters. The predictive ability of the dividend-price ratio for dividend growth is slightly stronger for stock returns, but the conclusion reverses at longer horizons of three and five years. In contrast, at both short and long horizons, the predictive ability of the earnings-price ratio for earnings growth is significant in all local periods, stronger for stock returns and dividend payout ratios. Surprisingly, dividend smoothing matters for cash flow predictability at the low frequency only. Moreover, the two valuation ratios predict either expected future discount rates or cash flows, or both, for most sample periods, indicating that the present-value relation holds precisely in local periods