Stock Return Predictability: Evidence from Price-Dividend Components

Citation

McMillan D (2026) Stock Return Predictability: Evidence from Price-Dividend Components. Studies in Economics and Finance. https://doi.org/10.1108/SEF-10-2024-0675

Abstract
Purpose Stock return predictability remains a key empirical research question, partly because evidence is mixed. Predictability is expected based on the dividend discount model, a prominent asset pricing model that, as an additional interest, can be used to distinguish between the risk and cash flow channels for price movement. This research tests for predictability across a range of markets for both predictability and the dominant avenue for asset price movement. Design/methodology/approach Using a US and separate G7 data set, we test for price-dividend ratio predictability both in terms of the raw series and through the different components relating to breaks (that coincide with inflationary regimes) and a trend (or long cycle) and cycle (or short cycle) decomposition (that relate to fundamental and transitory factors). These predictive regressions are supported by an out-of-sample forecast exercise and use of consumption growth predictability, which sheds light on the risk versus cash flow avenues for asset pricing. Findings We show that price-dividend ratio predictability is masked by the components relating to breaks and the trend and cycle decomposition. Once these components are accounted for, strong evidence of predictability for both stock returns and dividend growth emerges. This lends weight to both the risk and cash flow channels. Consumption growth predictability also supports the cash flow channel as a source of asset price movement. A comparison of different decomposition approaches (break, trend/cycle, and break with trend/cycle) show that all methods improve over the raw price-dividend ratio. The out-of-sample forecast exercise confirms these results. Originality Overall, the nature of predictability is revealed only once account for different components is made. Jointly incorporating breaks with the trend/cycle decomposition appears to be of notable importance and provides the preferred results.

Keywords
Stock returns; Price-dividend ratio; Dividend growth; Consumption Growth; Breaks; Trend and cycle; Predictability; C22; G12