Stock Return Predictability : Is it There?

We ask whether stock returns in France, Germany, Japan, the UK and the US are predictable by three instruments: the dividend yield, the earnings yield and the short rate. The predictability regression is suggested by a present value model with earnings growth, payout ratios and the short rate as state variables. We use this model imposing a constant risk premium to examine the finite sample evidence on predictability. Not only do we find the short rate to be a relevant state variable theoretically, it is also the only robust short-run predictor of equity returns. The evidence in Lamont (1998) on earnings and dividend yield predictability is not robust to our increased sample period, does not survive finite sample corrections and does not extend to other countries. We find no evidence of long-horizon predictability once we account for finite sample influence. Finally, cross-country predictability appears stronger than predictability using local instruments