Growth Expectations, Dividend Yields, and Future Stock Returns
According to the dynamic version of the Gordon growth model, the long-run expected return on stocks, stock yield, is the sum of the dividend yield on stocks plus some weighted average of expected future growth rates in dividends. We construct a measure of stock yield based on sell-side analysts' near-term earnings forecasts that predicts US stock index returns well, with an out-of-sample R-squared that is consistently above 2% at monthly frequency over our sample period. Stock yield also predicts future stock index returns in the US and other G7 countries and returns of US stock portfolios formed by sorting stocks based on firm characteristics, at various horizons. The findings are consistent with a single dominant factor driving expected returns on stocks over different holding periods. That single factor extracted from the cross section of stock yields using the Kelly and Pruitt (2013) partial regressions method predicts stock index returns better. The performance of the Binsbergen and Koijen (2010) latent factor model for forecasting stock returns improves significantly when stock yield is included as an imperfect observation of expected return on stocks. Consistent with folk wisdom, stock returns are more predictable coming out of a recession. Our measure performs as well in predicting stock returns as the implied cost of capital, another common stock yield measure that uses additional information.
We thank Binying Liu for excellent research assistance and valuable comments. We also thank Ben Golez, Shane Johnson, Hwagyun Kim, Qinghao Mao, Yu Yuan, and seminar participants at Erasmus University, Indian School of Business, Shanghai Advanced Institute of Finance (SAIF), Texas A&M University, and University of Notre Dame. We are grateful to Ken French, Amit Goyal, Robert Shiller, Bhaskaran Swaminathan, and Hao Zhou for sharing their data with us. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.