The Predictability of Returns with Regime Shifts in Consumption and Dividend Growth

Abstract

The predictability of the market return and dividend and consumption growth is addressed in an equilibrium model with two regimes. A state variable that drives the conditional means of the aggregate consumption and dividend growth rates follows different time-series processes in the two regimes. In linear predictive regressions over 1930-2009, the market return is predictable by the market-wide price-dividend ratio with R2 11.7% if the probability of being in the first regime exceeds 50%; and dividend growth is predictable by the price-dividend ratio with R2 28.3% if the probability of being in the second regime exceeds 50%. The model-implied state variables perform significantly better at in-sample and out-of-sample prediction of the equity, size, and value premia, aggregate consumption and dividend growth rates, and variance of market return than linear regressions with the price-dividend ratio and risk free rate as predictive variables.

Keywords: Return Predictability, Consumption Growth Predictability, Dividend Growth Predictability, Regime Shifts, Cross-Section of Returns, Equity Premium, Size Premium, Value Premium

JEL Classification: G12, E44