Growth Expectations, Dividend Yields, and Future Stock Returns

According to the present value model, the long-run expected return on stocks, stock yield, is the dividend yield on stocks plus a weighted average of expected future growth rates in dividends. We construct a measure of the expected stock yield using the realized dividend yield and a weighted average growth rate proxy from sell-side analysts near-term earnings forecasts. During 1977-2012, this simple measure performs as well as other methods proposed in the literature for predicting US stock market returns, in sample as well as out of sample in real time. For example, its out-of-sample R-square is consistently above 2% at monthly level, better than two of the best performing models for this time period: models based on ICC and partial least squares that have received attention in the literature for forecasting equity returns. In sample, expected stock yield predicts future stock market return with an adjusted R-square of 13% at one year, up to 54% at four years in US. It also performs well for predicting the return on stock markets in other G7 countries and US portfolios formed by sorting stocks based on rm characteristics such as book-to-market ratio, size, and industry. The out-of-sample performance can be further improved by incorporating stock yield in an additional observation equation in the present-value model of Binsbergen and Koijen (2010).