Predicting the Equity Premium with Dividend Ratios : Reconciling the Evidence

This paper evaluates the ability of dividend ratios to predict the equity premium. We conduct an out-of-sample comparative study and apply the Goyal and Welch (2003) methodology to equity premia derived from the UK FTSE All-Share and the Samp;P 500 indices. Preliminary in-sample univariate regressions reveal that in both markets the equity premium contains an element of predictability. However, out-of-sample the considered models outperform the historical moving average only in the UK context. This is confirmed by the graphical diagnostic which further indicates that dividend ratios are useful predictors of UK excess returns. Our paper provides a possible explanation of why dividend ratios might be more informative in the UK market and links these findings to a phenomenon that is not widely known in the predictability literature. Finally, Campbell and Shiller (1988b) identities are employed to account for the time-varying properties of the dividend ratio and dividend growth processes. It is shown that by instrumenting the models with the identities, forecasting ability can be further improved