Swedroe: Do Price Multiples Predict Market Returns?

April 03, 2017

A large body of work demonstrates that price multiples, such as the dividend-to-price ratio, predict stock returns. As a result, modern asset pricing theory increasingly incorporates time-varying expected returns. The majority of the empirical work underpinning these findings uses U.S. stock market data going back to 1926.

Benjamin Golez and Peter Koudijs contribute to the literature on return predictability with their January 2017 study, “Four Centuries of Return Predictability.” They examined whether dividend yields predict returns in a sample that covers four centuries of data, going back to the stock market’s earliest years in the 17th century.

Thus, they provide an out-of-sample test on whether results that hold in the recent U.S. period are generalizable to other times and places. Their sample covers annual stock market data for the most important equity markets of the last four centuries: the Netherlands/U.K. (1629‒1812), U.K. (1813‒1870) and U.S. (1871‒2015).

They analyzed the data for each subperiod individually and for the sample as a whole, asking whether the dividend-to-price ratio forecasts returns over the succeeding one-, three- and five-year periods.

Summary Of Finds

  • Annual nominal returns are 8% on average, and vary between 6% in the early data and 12% in the recent U.S. period.
  • While inflation is much higher after 1945, average real returns across periods are more similar, varying between 6% and 8%.
  • Returns are more volatile after 1870; the standard deviation of real returns is roughly 50% higher compared with the earlier periods.
  • Estimated risk premiums were relatively low in the early part of the data, 2 to 3%, in comparison with 6 to 8% in the U.S. after 1870.
  • Annual real dividend growth rates are around 2% on average. In the 17th and 18th centuries, they are below 1%, picking up in the 19th century, with an average growth rate of 5% before falling to about 2% in the later part of the data.
  • For the entire period, most of the real return to investors has come from dividend yields, with 37% coming from price appreciation. However, this has changed in the most recent period, where price appreciation accounts for 57% of real returns.
  • With 384 annual observations, the authors were able to reject the null hypothesis of no return predictability over both short and long horizons—dividend yields do predict returns.
  • Expected returns are time-varying and related to the business cycle, with expected returns increasing in recessions.
  • The dividend-to-price ratio predicts dividend growth rates, but only for the period before 1945. The dramatic fall in the propensity of firms to pay dividends may explain this change. During the 17th and 18th centuries, firms paid out close to 100% of their earnings to shareholders. In 1945, this number was still around 80%. By 1982, however, the dividend-to earnings ratio had fallen to approximately 45%.


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