The Conditional Relationship between the Equity Risk Premium and the Dividend Price Ratio

Abstract

The dividend price ratio is among the most commonly proposed instruments for forecasting equity returns. Despite an ongoing debate struggling to establish the efficacy of regressions using the dividend price ratio to measure the conditional equity premium, such affine functions are now pervasive in literatures that use the conditional equity premium as an input. In this paper, I point out that economic models of risk speak directly to the properties of predictability regression statistics. Specifically, I demonstrate that in reasonable theoretical settings, predictability regressions may be badly misspecified. In particular, they may have low power to identify the conditional and nonlinear form of predictability suggested by structural treatments of risk. Additionally, simple predictive regressions produce estimates of the conditional risk premium which may be very different from the true values. Moreover, accommodating the implied instability in the relationship between the dividend price ratio and the equity risk premium can substantially improve out of sample forecasting power.

Keywords: stock return, predictability, dividend yield, dividend price ratio

JEL Classification: G12, G14