Title: Stock return predictability and cyclical movements in valuation ratios
Authors: Deshui Yu - Hunan University (China)
Difang Huang - Monash University (Australia)
Li Chen - Xiamen University (China) [presenting]
Abstract: According to present-value models, valuation ratios should predict future stock returns or cash flows but empirically show little power. The aim is to develop insights about stock return predictability, and to reconcile the contradicting findings. We decompose a valuation ratio into (i) a slow-moving component which reflects the local time-varying expected values of the valuation ratio as the results of persistent shocks, and (ii) a cyclical component which reflects rapid mean-reversion toward to the time-varying mean. The cyclical components of valuation ratios show statistically significant power for predicting future stock returns, both in-sample and out-of-sample, and the predictability is also economically significant. Conversely, the slow-moving components fail to predict returns, and therefore the components disguise the predictive information contained in valuation ratios for future returns. To ascertain our findings, we provide a direct line linking the decomposition approach to the present-value framework and the system of predictive regression.