Stock Return Predictability and Cyclical Movements in Valuation Ratios

According to present-value models, a financial valuation ratio should predict future stock returns or cash flows but empirically shows little power. This paper develops insights about stock return predictability and reconciles the contradicting findings. We decompose a financial ratio into (1) a slow-moving component which reflects the local time-varying expected values of the financial ratio as the results of persistent shocks, and (2) a cyclical component which reflects a more rapid mean-reversion of the financial ratio toward the local time-varying mean. The cyclical component shows statistically significant power for predicting future stock returns, both in-sample and out-of-sample, and the predictability is also economically significant. Conversely, the slow-moving component fails to predict returns and therefore disguises the predictive information contained in the dividend-price ratio for future returns. To ascertain our findings, we provide a direct line linking our decomposition approach to the present-value framework and the predictive regression system