The Predictability of Returns with Regime Shifts in Consumption and Dividend Growth
The predictability of the market return and dividend growth is addressed in an equilibrium model with two regimes. A state variable that drives the conditional means of the aggregate consumption and dividend growth rates follows different time-series processes in the two regimes. In linear predictive regressions over 1930-2009, the market return is predictable by the price-dividend ratio with R2 11.7% if the probability of being in the first regime exceeds 50%; and dividend growth is predictable by the price-dividend ratio with R2 28.3% if the probability of being in the second regime exceeds 50%. The model-implied state variables perform significantly better at predicting the equity, size, and value premia, the aggregate consumption and dividend growth rates, and the variance of the market return than linear regressions with the market price-dividend ratio and risk free rate as predictive variables.
We thank John Cochrane, Rick Green, Lars Hansen, John Heaton, Burton Hollifield, Christian Julliard, Oliver Linton, Bryan Routledge, Duane Seppi, Pietro Veronesi and seminar participants at Carnegie Mellon University, the University of Chicago, and the Sixth Annual Early Career Women in Finance Mini-Conference for helpful comments. We remain responsible for errors and omissions. Ghosh acknowledges financial support from Carnegie Mellon University. Constantinides acknowledges financial support from the Center for Research in Security Prices of the University of Chicago Booth School of Business. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.