A Variance Decomposition for Stock Returns
NBER Working Paper No. 3246 (Also Reprint No. r1615)
This paper shows that unexpected stock returns must be associated with changes in expected future dividends or expected future returns A vector autoregressive method is used to break unexpected stock returns into these two components. In U.S. monthly data in 1927-88, one-third of the variance of unexpected returns is attributed to the variance of changing expected dividends, one-third to the variance of changing expected returns, and one-third to the covariance of the two components. Changing expected returns have a large effect on stock prices because they are persistent: a 1% innovation in the expected return is associated with a 4 or 5% capital loss. Changes in expected returns are negatively correlated with changes in expected dividends, increasing the stock market reaction to dividend news. In the period 1952-88, hanging expected. returns account for a larger fraction of stock return variation than they do in the period 1927-51.
Published: The Economic Journal, Vol. 101, No. 405, pp. 157-179, (March 1991).