Working Paper: CEPR ID: DP16613
Authors: Juan Francisco Rubio-Ramirez; Ivan Petrella; Juan Antolin-Diaz
Abstract: A long tradition in macro-finance studies the joint dynamics of aggregate stock returns and dividends using vector autoregressions (VARs), imposing the cross-equation restrictions implied by the Campbell-Shiller (CS) identity to sharpen inference. We take a Bayesian perspective and develop methods to draw from any posterior distribution of a VAR that encodes a priori skepticism about large amounts of return predictability while imposing the CS restrictions. In doing so, we show how a common empirical practice of omitting dividend growth from the system amounts to imposing the extra restriction that dividend growth is not persistent. We highlight that persistence in dividend growth induces a previously overlooked channel for return predictability, which we label "dividend momentum." Compared to estimation based on OLS, our restricted informative prior leads to a much more moderate, but still signi cant, degree of return predictability, with forecasts that are helpful out-of-sample and realistic asset allocation prescriptions with Sharpe ratios that out-perform common benchmarks.
Keywords: Dividend Momentum; Stock Return Predictability; Bayesian Approach
JEL Codes: C32; C53; E47
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Omitting dividend growth from the VAR system (C22) | Incorrect assumption that dividend growth is not persistent (G35) |
| Omitting dividend growth from the VAR system (C22) | Significant gap in understanding return predictability (G17) |
| Persistent dividend growth (G35) | Positive correlation between current and future returns (G17) |
| Shock that increases both returns and dividends (G19) | Sustained positive dividend growth (G35) |
| Sustained positive dividend growth (G35) | Increased future returns (G17) |
| Initial shock to returns and dividends (G19) | Feedback loop that reinforces predictability of returns (G17) |
| Bayesian approach (C11) | More realistic assessment of return predictability (G17) |
| Presence of dividend momentum (G35) | Alters optimal investment strategy for long-horizon investors (D15) |
| Dividend momentum (G35) | Increases expected variance of stock returns (G17) |
| Dividend momentum (G35) | Affects hedging demand for stocks (G41) |