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How Well Do Financial and Macroeconomic Variables Predict Stock Returns

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How Well Do Financial and Macroeconomic Variables Predict Stock Returns : Time –Series and Cross-Sectional Evidence   

This paper investigates a series of variables which are found to be predictors of the stock market in the financial literature.  

  • Dividend yield and earning yield: Fama and French (1988a) and Campbell and Shiller  (1988)  
  • Corporate bond spread: Fama and French (1989) 
  • Change in 3-month t-bill rate: Campbell (1991) and Hodrick (1992) 
  • Price-output ratio: Rangvid (2006) 
  • Price-consumption ratio: Menzly et al. (2004) 
  • Labor-income to consumption ratio: Santos and Veronesi (2005) 
  • Non-housing expenditure share: Piazzesi et al. (2006)  
  • Deviation of consumption from asset wealth and labor income (cay): Lettau and Ludvigson (2001a) 
  • Deviation of consumption from dividends and labor income (cdy): Lettau and Ludvigson (2005) 
  • “Cay” and future labor income: Julliard (2004) 
  • Dividend and labor income: Benzoni et al. (2006) 
  • Ratio of housing wealth to human wealth: Lustig and Nieuwerburgh (2005) 

The author first runs long-horizon time-series univariate regressions to study the predictability of the aggregate stock return by the different variables. She discusses in details the unit-root and cointegration properties of the variables (in particular the macro variables). She also implements mutivariate regressions to select the most signifcant variables.

She then performs a cross-sectional analysis the Fama and French portfolios (25 portfolios sorted by size and value):

A good forecasting variable should be able to better price the cross-section of returns within the framework on the conditional C-CAPM.

She runs Fama-McBeth regressions to estimate the price of risks of consumption and consumption time the factor and then analyzes the different pricing errors for each portfolio.

She finds that overall, price-dividend, price-earnings, price-output, price consumption ratios and the consumption-aggregate wealth ratio are the best predictors of future returns. 

The paper is available here:


Benzoni, L., P. Collin-Dufresne, and R. S. Goldstein (2006, Jan.), “Portfolio choice over the life-cycle when the stock and labor markets are cointegrated,” Working paper, University of Minnesota and UCLA.

Campbell, John Y. (1991), “A Variance Decomposition for Stock Returns,” Economic Journal, vol. 101, 157–179.

Campbell, John Y. and Robert J. Shiller (1988), “Stock Prices, Earnings, and Expected Dividends,” Journal of Finance, vol. 43, 661–676.

Fama, Eugene F. and Kenneth R. French (1988a), “Dividend Yields and Expected Stock Returns,” Journal of Financial Economics, vol. 22, 3–25.18

Fama, Eugene F. and Kenneth R. French (1988b), “Permanent and Temporary Components of Stock Prices,” Journal of Political Economy, vol. 96, 246–273.

Fama, Eugene F. and Kenneth R. French (1989), “Business Conditions and Expected Returns on Stocks and Bonds,” Journal of Financial Economics, vol. 25, 23–49.

Hodrick, Robert J. (1992), “Dividend Yields and Expected Stock Returns: Alternative Procedures for Inference and Measurement,” Review of Financial Studies, vol. 5, 357–386.

Julliard, C. (2004, Oct.). Labor income risk and asset returns. Working Paper, Princeton University.

Lettau, M. and S. Ludvigson (2001a), “Resurrecting the (C)CAPM: A cross-sectional test whenrisk premia are time-varying,” Journal of Political Economy 109 (6), 1238-1287.

Lettau, M. and S. C. Ludvigson (2005), “Expected returns and expected dividend growth,” Journalof Financial Economics 76, 583-626.

Lustig, H. and S. V. Nieuwerburgh (2005, June); “Housing collateral, consumption insurance andrisk premia: an empirical perspective,” The Journal of Finance 60 (3), 1167-1219.

Menzly, L., T. Santos, and P. Veronesi (2004), “ Understanding predictability,” Journal of Political Economy 112 (1), 1-47.

Piazzesi, M., M. Schneider, and S. Tuzel (2006), ”Housing, consumption, and asset prising,” WorkingPaper, University of Chicago, NYU and USC.

Rangvid, J. (2006), “Output and expected returns,” Journal of Financial Economics 81 (3), 595-624.

Santos, T. and P. Veronesi (2005, March). Labor income and predictable stock returns. WorkingPaper, Columbia University and University of Chicago. 

See also {ln:Stock Return Predictability: Is it There?}.



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