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Do Decomposed Financial Ratios Predict Stock Returns and Fundamentals Better?

Xiaoquan Jiang* and Bong-Soo Lee**

This version: November 2009



Abstract

We investigate the prediction of excess returns and fundamentals by financial ratios --
dividend-price ratio, earnings-price ratio, and book-to-market ratio -- by decomposing
financial ratios into a cyclical component and a stochastic trend component. We find both
components predict excess returns and fundamentals. The cyclical components predict
increases in future stock returns, while the stochastic trend components predict declines in
future stock returns, in particular, in long horizons. This helps explain previous findings that
financial ratios in the absence of decomposition find weak predictive power in short horizons
and some predictive power in long horizons. We also find both components predict
fundamentals, consistent with present value models.

JEL classification: G12; G14
Keywords: Financial ratios; Return predictability; Decomposition; Fundamentals

* Department of Finance, College of Business Administration, Florida International
University, Miami, FL 33199; Phone: (305) 348-7910; Fax: (305)348-4245. Email:
jiangx@fiu.edu.
** Department of Finance, College of Business, Florida State University, Tallahassee, FL.
32306; Phone: (850) 644-4713; Fax: (850) 644-4225; Email: blee2@cob.fsu.edu.

We would like to thank the participants in the 2008 27
th
SUERF Colloquium (European
Finance and Money Forum), 2008 FMA, and 2009 SFA for helpful comments.

1
Whether financial ratios, such as dividend-price ratio, earnings-price ratio, and book-to-
market ratio, predict future stock returns has drawn much attention from both practitioners
and academics. The prediction of stock returns using financial ratios is theoretically rooted
in present value models (e.g., the dividend discount model, earnings discount model, and
residual income model). These models imply that stock return is determined by fundamentals
embedded in financial ratios. Using a log linear present value model, Campbell and Shiller
(1989) demonstrate that the dividend-price ratio is either positively associated with future
stock returns or negatively associated with future dividend growth rates. Empirical evidence
generally suggests that financial ratios can predict future stock returns, especially in long
horizons.
1
In contrast, short horizon returns and the growth of fundamentals are more difficult
to predict.
A consensus view of a quarter-century of empirical work has been summarized in
Cochranes book, Asset Pricing (2001, p. 388). To quote:
2. Returns are predictable. In particular, (a) Variables including the dividend/price ratio
and term premium can in fact predict substantial amounts of stock return variation. This
phenomenon occurs over business cycle and longer horizons. Daily, weekly, and monthly
stock returns are still close to unpredictable
Recently, this view has been questioned and challenged on several grounds. First, the
statistical inference is problematic. It is well known that financial ratios are very persistent,
and return shocks are negatively correlated with financial ratios. Because of the near-unit-
root property of financial ratios, the statistical inference leads to uninformative inference on
the prediction relation (e.g., Nelson and Kim, 1993; Stambaugh, 1999; Ferson, Sarkissian, and
Simin, 2003; Valkanov, 2003; Lewellen, 2004). Ang and Bekaert (2007) provide evidence
that dividend yields do not significantly predict excess returns at long horizons after carefully
accounting for small sample properties of standard tests. Goyal and Welch (2003, 2008)
show that financial ratios have poor out-of-sample forecast power.
Second, it is not clear how much predictive power can be attributed to financial ratios.
Summers (1986), Fama and French (1988), and Campbell and Shiller (1989, 2005) suggest a

1
See Rozeff (1984), Fama and French (1988), Pontiff and Schall (1998), Campbell and Shiller (1988, 1989,
2005), Cochrane (1992, 2008), Goetzman and Jorion (1993), Hodrick (1992), Lewellen (2004), Lettau and
Ludvigson (2005), Hecht and Vuolteenaho (2006), Jiang and Lee (2007), Lettau and Nieuwerburgh (2008), and
others.
2
simple theory of slow mean reversion to explain the predictive power. That is, stock prices
cannot drift too far from their fundamentals (e.g., dividend, earnings, and book value) in the
long run. The theory of slow mean reversion requires financial ratios to be stationary. Figure
1, however, shows that all financial ratios exhibit a downward trend for the sample period of
1926 to 2008.
2
Lamont (1998) argues that fundamentals predict returns in the short run, while
prices predict returns in the long run.
Third, the prediction relation between returns and financial ratios appears to suffer
from structural instability over time. Especially, in the late 1990s, the prediction relation
seems not robust (see, Viceira, 1996; Lettau and Ludvigson, 2001; Goyal and Welch, 2003;
Paye and Timmermann, 2006; Lettau and Van Nieuwerburgh, 2008).
Given these controversies, we reexamine the predictive power of financial ratios in
predicting stock returns and fundamentals. For this purpose, we propose decomposing
financial ratios into a cyclical component and a stochastic trend component using Hodrick and
Prescotts (1997) Kalman filter procedure. To address a finite sample bias in the forecasting
regressions, we use the bootstrap simulation procedure in testing the null hypothesis of no
predictability. To circumvent the look-ahead bias in the out-of-sample forecasts, we provide
an alternative decomposition.
Using the decomposed components of financial ratios, we find that both excess returns
and fundamentals are significantly predictable for the sample periods from 1926:Q1 to
2008:Q4 and from 1952:Q1 to 2008:Q4. The cyclical components of financial ratios predict
an increase in stock returns, while the stochastic trend components of financial ratios predict a
decrease in stock returns. Their predictive power peaks at horizon of around twelve quarters.
At the horizon of twelve quarters for the sample period from 1926:Q1 to 2008:Q4, the
explanatory powers (R
2
s) of the two components of dividend-price ratio, earnings-price ratio,
and book-to-market ratio are 45%, 72%, and 77%, respectively. The cyclical components tend
to dominate the stochastic trend component in the explanatory power. Consistent with present
value models, we also find that both components predict fundamentals. For example, for
dividend price ratio, we find the cyclical component tends to predict dividend growth with a

2
The assumption of stationarity of financial ratios is often suspected. The empirical evidence on the stationarity
of financial ratios is mixed.
3
negative coefficient while the stochastic trend component tends to predict dividend growth
with a positive coefficient.
The other objective of the paper is to explore the channels through which returns are
predicted so that we can provide better understanding of previous findings that financial ratios
predict stock returns little in short horizons while they show some predictive power in long
horizons. For example, the log dividend ratio model anticipates that an increase in this
financial ratio is associated with future increases in stock returns and/or future declines in
dividend growth rates. Return forecast literature generally attributes the forecast power of
financial ratios to (slow) mean reversion (see Campbell and Shiller 1989, 2005).
3
We find
that the cyclical component of the log dividend price ratio predicts increases in stock returns
while the stochastic trend component of this ratio predicts decreases in stock returns. We
interpret this as evidence of the cyclical component reflecting a local mean reversion effect,
while the stochastic trend component reflecting a long-run persistence effect. Ferson and Xie
(2009) find that the long-run risk models better capture momentum effect, which is consistent
with this persistent effect. By decomposing the financial ratios into two components, we
show that financial ratios better predict both stock returns and fundamentals.
Therefore, we find returns and fundamentals are predictable through two channels. In
particular, we find that the stochastic trend components are persistent and show higher R
2
s in
long horizons. This indicates that the long-run persistence in the stochastic trend components
of financial ratios is particularly effective in long horizons. Since the stochastic trend
components tend to be more important in the financial ratios in long horizons, this helps
explain previous findings that raw financial ratios tend to show some predictive power for
stock returns in long horizons. In addition, our finding that the two components predict stock
returns in the opposite directions suggests that, in short horizons, the two components of
financial ratios tend to offset much of each others prediction. This helps explain the failure
of previous studies to find strong predictive power of raw financial ratios in short horizons in
the absence of decomposition.
Our evidence also helps explain why the dividend price ratio does not predict dividend
growth. Lettau and Ludvigson (2005) argue that the failure of dividend price ratio to predict

3
In fixed income literature, Fama (2006) also proposes local mean reverting and slow mean reverting
components to study the behavior of interest rates.
4
dividend growth is due to the positive correlation between the expected return and expected
dividend growth, suggesting that time-varying investment opportunities are poorly captured
by dividend price ratio. Our evidence suggests these investment opportunities are captured
separately by each components of dividend price ratio, and the failure of dividend price ratio
to predict dividend growth is due to the offsetting effect between the cyclical and stochastic
trend components.
The idea of decomposing financial variables is not new. Fama and French (1988)
decompose stock prices into temporary and permanent components to demonstrate that a
slowly mean-reverting component of stock prices tends to induce a negative autocorrelation in
returns (see also Lee, 1998). Cochrane (1994) studies a bivariate cointegrated system to
characterize the temporary and permanent components in GNP and stock prices. Lettau and
Ludvigson (2001, 2005) study how the temporary and permanent components of net worth are
related to consumer spending. However, we are the first to employ the decomposition of
financial ratios in the prediction of returns and fundamentals.
Similarly, Lettau and Van Nieuwerburgh (2008) suggest that the puzzling empirical
patterns in return prediction are caused by the changes in the steady-state mean of financial
ratios. They estimate regime-switching models for the steady-state mean of financial ratios.
In regime-switching or structural break models, however, the number of parameters to be
estimated grows rapidly with the number of regimes or breaks. Generally, two or at most
three regimes are allowed, and more regimes imply a lower power. The permanent change in
the financial ratios can be attributed to technological innovations, changes in market
participations, tax codes, and so on. As such, two or three regimes may not suffice.
In this paper, we employ Hodrick and Prescotts Kalman filter procedure in
decomposing financial ratios into stochastic trend and cyclical components, which is more
flexible than allowing for regimes. Intuitively, the stochastic trend component is measured as
a weighted average of financial ratio over time, and cyclical component is measured as
residuals. The main reason for employing Hodrick and Prescotts filter is two folds. In terms
of methodology, Hodrick and Prescotts Kalman filter procedure is very flexible. It can be
used to decompose highly persistent stationary series (e.g., value premium in Chen, Petkova
and Zhang, 2007) as well as nonstationary series (e.g., GDP). This is particularly useful for
financial ratios because it is still debated whether financial ratios contain a unit root. In theory,
5
they are expected to be stationary as we can see from various present value models. However,
empirical studies find that they are highly persistent with a downward trend (see Figure 1).
Fama and French (2002, 2007), Vuolteenaho (2002), Campbell and Shiller (1998, 2005),
Campbell (2007), Jiang and Lee (2007), and Lettau and Nieuwerburgh (2008) provide similar
evidence.
In terms of economic and finance intuition, Blanchard and Watson (1982) and Froot
and Obstfeld (1992) show that, if stock price is allowed to deviate from its intrinsic value (i.e.,
if bubbles are allowed), regardless of whether they are rational or irrational, financial ratios
can be decomposed into two parts: the random walk and bubbles.
4
Campbell and
Vuolteenaho (2004) show that returns generated by discount rate risk are offset by lower
returns in the future (mean reversion), whereas returns generated by cash flow risk are never
reversed subsequently (persistence). Motivated by this insight, we interpret the predictive
power of cyclical components of financial ratios as due to a local mean reversion, and that of
stochastic trend components of financial ratios as due to a long-run persistence effect.
Similarly, Fama and French (2007), in studying average returns on value and growth
portfolios, employ a decomposition of capital gains into three sources: growth in book value,
convergence in P/B ratios, and drift in P/B. Another advantage is that besides the cyclical
component, it also generates the long-run stochastic trend component which is time-varying
and can be used as a predictor.
Fama and French (2002) argue that average stock return of the last half century is a lot
higher than expected. The observation that financial ratios are very low in 1990s while stock
returns remain high makes the return prediction more difficult. The decomposed financial
ratios help us better predict returns both in short and long horizons. Using the consumption-
wealth ratio (CAY), Lettau and Ludvigson (2001, 2005) find that excess returns are
predictable. Consistent with Lettau and Ludvigson (2001, 2005) and Ang and Bekaert (2007)
we find both CAY and relative T-bill rates are able to predict stock returns in the univariate
regression. However, when we include the two components of financial ratios in the
prediction regression, the predictive power of CAY and relative T-bill rates tends to disappear,
while both the cyclical and stochastic trend components of financial ratios predict stock

4
Wu (1997) uses a similar Kalman filter to decompose price-dividend ratio to account for U.S. stock price
volatility.
6
returns significantly in all horizons considered. We find that the two components of financial
ratios have more predictive power than consumption-wealth ratios and relative T-Bill rates.
We also find that dividend growth, earnings growth, and accounting returns are
predictable using the cyclical and stochastic trend components of financial ratios. Dividend
growth is typically predictable by the cyclical component of dividend-price ratio, especially in
short horizons. Accounting returns are predictable by the stochastic trend component of
book-to-market ratio, in particular, in long horizons. Earnings growth is predictable by the
cyclical component of the earning-price ratio in short horizons and by the stochastic trend
component of the earning-price ratio in long horizons.
Ferreira and Santa-Clara (2009) propose an alternative method, the sum-of-parts
method (SOP), to decompose stock returns (left-hand side) into three components, the
dividend yield, the earnings growth rate, and the growth rate in the price-earnings ratio.
They show that SOP method performs remarkably well on data from the U.K. and Japan,
where there is even stronger predictability in stock returns than in the U.S.
The paper is organized as follows. In Section 1, we present the theoretical and
empirical frameworks and the financial ratio decompositions. In Section 2, we provide data
description and preliminary results. In Section 3, we examine the predictive power of two
components of financial ratios at various horizons. In Section 4, we provide the results of
out-of-sample predictions, and we conclude in Section 5.

1. Methodology

1.1 Decomposition procedure
In view of Figure 1, which shows highly persistent financial ratios, and considering the
insights provided by Fama (2006) and Lettau and Ludvigson (2005) and methodologies
developed by King, Plosser, Stock, and Watson (1991) and Hodrick and Prescott (1997), we
decompose financial ratios into a stochastic trend component and a cyclical component. For
decompositions, we use the Hodrick and Prescott (1977) method. This is because the method
reflects neoclassical economic theory (see Lucas, 1980, 1981) with a flexible design, and it is
one of popular decompositions in the literature.
7
Let FR
t
be a log financial ratio at time t. FR
t
can be log dividend-price ratio, log
earnings-price ratio, or log book-to-market ratio. Following Hodrick and Prescott (1977), we
model FR
t
as

FR
t
= G
t
+ C
t
, (1)

where G
t
is a stochastic trend component that varies smoothly over time, and C
t
is a cyclical
component. Since the cyclical component is the residual, it should be close to zero on
average in the long run.
The stochastic trend component can be obtained by solving the following
programming problem:

2 2
1 2
{ }
1 1
[ 2 ]
t
T T
t t t t
G
t t
Min C G G G

= =

+ +



, (2)
where is a positive parameter that penalizes variability in the stochastic trend component.
The larger the value of , the smoother the stochastic trend component.
There are two attractive properties in this decomposition for predicting returns. First,
the cyclical component, C
t
, is stationary and not persistent. It is well known that highly
persistent predictors tend to lead to a small sample problem (Stambaugh, 1986, 1999) and
spurious predictions (Ferson, Sarkissian, and Simin, 2003). A stationary cyclical component
is less subject to these criticisms.
5
Second, the stochastic trend component is smooth and
flexible compared to regime-switching models. It captures fundamental structural changes
well.
Hodrick and Prescott (1997) recommend using the Kalman filter procedure to identify
the unobservable stochastic trend component. We employ the following state-space
representation:
Measurement equation:

1
[1, 0] .
t
t t
t
G
FR C
G

= +


(3)
Transition equation:

5
In forecasting regressions, we use the first-difference of the stochastic trend component.
8

1
1 2
2 1
.
1 0
t t
t t
G G
G G

=


(4)
A nice property of the AR(2) process of G
t
is that it allows the cyclical component to be
periodic with a peak in its spectral density function, which implies a positive short-run
autocorrelation (momentum) and a negative long-run autocorrelation (mean reversion).
6

Given equations (3) and (4), we employ the Kalman filter procedure to estimate the stochastic
trend and cyclical components.

1.2 Models of financial ratios
Consider the definition of log one-period returns:
log(1+R
t
)

log(P
t
+D
t
) log(P
t-1
), (5)

where R
t
is the realized return during the period t, P
t
is the real price of a stock or a stock
portfolio measured at the end of time period t, and D
t
is the real dividend paid on the portfolio
during period t. Campbell and Shiller (1989) assume that the ratio of the price to the sum of
price and dividend is approximately constant through time at the level . That is, =
P/(P+D), where P and D are the mean values of stock price and dividend, respectively. By
using a Taylor approximation, they derive the following equation:

r
t
= p
t
+ (1-) d
t
p
t-1
+ k, (6)

where the lowercase letters represent logs of the corresponding uppercase letters (e.g., r
t
= log
(1+R
t
)). The parameter is close to but a little smaller than 1, and k is a constant term. They
rewrite equation (6) in terms of the dividend-price ratio
t
(= d
t
p
t
) and the dividend growth
rate d
t
:
r
t
= k +
t-1
-
t
+ d
t
. (7)

Solving forward by imposing a transversality condition, ignoring a constant term and
taking the conditional expectation, they obtain


6
In macroeconomics literature, Harvey (1985) and Clark (1987), among others, decompose real GDP as AR(2)
process.
9

t
=

=
+ + + +
0
1 1
] [
j
j t j t
j
t t t
d r E p d . (8)

Equation (8) states that the spread, the log dividend-price ratio, is an expected discounted
value of all future returns and dividend growth rates discounted at the discount rate . That is,
the log dividend-price ratio is an expected discounted value of all future one-period growth-
adjusted discount rate, r
t+j
- d
t+j
. As such, the log dividend-price ratio provides the optimal
forecast of the discounted value of all future returns or future dividend growth rates, or both.
Lintner (1956), Marsh and Merton (1986), and Lee (1996a, 1996b, 1998) suggest that
dividends are associated with permanent earnings (i.e., the permanent earnings hypothesis of
dividends).
7
Similarly, Pindyck and Rotemberg (1993) express stock price as a present value
of future earnings. Combining Pindyck and Rotembergs present value model of earnings and
Campbell and Shillers dynamic present value model, we obtain

=
+ + + +
0
1 1
] [
j
j t j t
j
t t t
e r E p e , (9)
where e
t
denotes log earnings. Equation (9) states that the log earnings-price ratio provides
the optimal forecast of the discounted value of all future returns or future earnings growth
rates, or both.
Given unstable dividend policy and controversies about the appropriateness of using
dividends as a proxy for cash flows, Vuolteenaho (2000, 2002) proposes an alternative,
accounting-based, approximate present value model, the loglinear book-to-market-ratio model:

t
j
j t j t
j
t t t
k ar r E p b +

=
+ + + +
0
1 1
] [ , (10)
where ar
t
denotes accounting returns, and k
t
is an approximation error. Equation (10) states
that the log book-to-market ratio is an infinite discounted sum of expected future stock returns
and profitability. Analogous to the Campbell-Shiller model, the book-to-market ratio
provides the optimal forecast of the discounted value of all future returns or future accounting
returns, or both.

7
For the theoretical modeling of the idea of permanent earnings, see Lee (1996a, 1996b, 1998).
10
In the following discussions, the choice of financial ratios (dividend-price ratio,
earnings-price ratio, and book-to-market-ratio) and the prediction of returns and fundamentals
are based on equations (8), (9), and (10).

1.3 Predictive regressions
To examine whether the decomposition of financial ratios helps predict stock returns and
growth in fundamentals, we consider the following regressions:

, , t h t t t h
y FR
+
= + + , (11-a)

, , t h t t t h
y C
+
= + + , (11-b)

, , t h t t t h
y G
+
= + + , (11-c)

, , t h t t t t h
y C G
+
= + + + , (11-d)
where y
t,h
denotes

=
+ +

h
j
j t f j t
r r
1
,
) ( for return regressions or

=
+
h
j
j t
F
1
) ( for fundamentals
regressions. FR
t
denotes a financial ratio, which can be DP
t
(= d
t
- p
t
), EP
t
(= e
t
- p
t
), or BP
t
(=
b
t
p
t
). C
t
and G
t
represent the cyclical and stochastic trend components of financial ratios,
respectively. F
t
denotes fundamentals such as dividend growth, earnings growth and
accounting returns. We choose fundamentals to match financial ratios based on the present
value models (equations (8), (9), and (10)). For example, dividend growth is used as
fundamentals when the predictor is dividend-price ratio.

1.4 Econometric issues
Our forecast regression can be subject to a finite sample bias, although the persistence of the
cyclical and stochastic trend components is lower than that of financial ratios. As
documented by Kendal (1954), Stambaugh (1999), and Ferson, Sarkissian, and Simin (2003),
the finite sample bias in the forecast regressions can be substantial and misleading. We
address this issue by applying a bootstrap procedure. Our bootstrap follows Mark (1995) and
Goyal and Welch (2008) and imposes the null of no predictability in calculating the critical
values. We posit that the data are generated by the following system under the null
hypothesis of no predictability:
r
t+1
= o +e
1t+1
,
11
x
t+1
= p
0
+px
t
+e
2t+1
.
The bootstrap for calculating power follows the data generating process as:
r
t+1
= o +[x
t
+u
1t+1
,
x
t+1
= p
0
+px
t
+u
2t+1
,
where both [ and p are estimated by simple OLS using the full sample of the data. We
generate 10,000 bootstrapped time series by drawing with replacement from the residuals.
The initial observation, which precedes the sample of data and is used to estimate the models,
is selected by picking one date from the actual data at random. This bootstrap procedure
preserves not only the autocorrelation structure of the predictor variable, thereby being valid
under the Stambaugh (1999) specification, but also the cross-correlation structure of the two
residuals.
Another potential issue with our method is that our decomposition uses full sample,
similar to the construction of CAY in Lettau and Ludvigson (2001). Therefore, the out-of-
sample forecast is subject to the look-ahead bias. However, there is a tradeoff. The stochastic
trend component reflects the long-run relation and requires a longer sample to estimate the
component, while using full sample is subject to the look-ahead bias in the out-of-sample
forecast. We address this issue by using the moving average of most recent 25 years financial
ratios as a proxy for the stochastic trend component.
8
Then, we use the difference between
financial ratio and the stochastic trend component as a proxy for the cyclical component. By
doing so, we try to avoid the look-ahead bias as much as we can and show whether stochastic
trend and cyclical components are able to better predict stock returns and fundamentals.


2. Data

We use stock prices (P), dividends (D, four-quarter moving sum of dividends), and earnings
(E, four-quarter moving sum of earnings) of the S&P 500 Index from 1926:Q1 to 2008:Q4.
Following suggestions of Graham and Dodd (1934) and Campbell and Shiller (2005), we
employ a ten-year moving average to smooth earnings to circumvent the problems associated
with seasonality and earnings manipulation. Since the book value of the S&P 500 Index for
such a long period is not available, we use the clean surplus accounting relation to generate

8
Fama (2006) uses a similar approach in calculating the long-term expected spot rate.
12
book value (B
t
), assuming that the book and market values are identical at the beginning.
9

The risk-free rates (R
f
) are measured as one-month T-bill rates from CRSP. The
consumption-wealth ratio (CAY) is from Lettau and Ludvigson (2001). Inflation rates are
based on the Consumer Price Index from the Bureau of Labor Statistics.
We construct three financial ratios: log dividend-price ratio (DP), log earnings-price
ratio (EP), and log book-to-market ratio (BP). All the ratios are measured as the difference
between the log of fundamentals and log of prices.
10
Based on equations (8), (9), and (10),
we choose fundamentals DD, EE, and EB, which are constructed as the difference in log
dividends, the difference in log earnings, and the difference between log earnings and log
book value, respectively.
The decomposition of financial ratios into the two components requires the selection
of the smoothing parameter . We follow the suggestion by Hodrick and Prescott (1997) in
selecting . Assuming that the cyclical components and the second differences of the
stochastic trend components are identically and independently distributed, normal variables
with means zero and variances
2
1
and
2
2
, they suggest using = . /
2
2
2
1
As an initial
value for the smoothing parameter , we choose = 1,600, which is used by Hodrick and
Prescott (1997).
11

In Table 1, we report summary statistics of the three financial ratios (DP, EP, and BP),
their cyclical components (C
DP,
C
EP
, and C
BP
), their stochastic trend components (G
DP,
G
EP,
and G
BP
), consumption-wealth ratio (CAY), relative T-Bill rates (RTB), and log excess
returns (R). In Panel A, we report mean, standard deviation, autocorrelation, and unit-root
tests based on the augmented Dickey-Fuller test and the Philips-Perron test. We find that R,
CAY, and RTB are stationary, while all financial ratios are highly persistent. The first-order
autocorrelation of each financial ratio is greater than 0.96, and the null hypothesis of unit root
in DP and BP cannot be rejected by either the augmented Dickey-Fuller test or the Philips-

9
The clean surplus accounting relation requires that all gains and losses affecting book value are also included
in earnings; that is, the change in book value is equal to earnings minus dividends. This approach has been used
in both accounting and finance literature (See, Vuolteenaho, 2002; Jiang and Lee, 2006, 2007).
10
See Campbell and Shiller (2005).
11
For the robustness of our results, we also use =1,600 to decompose the financial ratios. The results are very
similar. We do not report the result to save space.
13
Perron test.
12
Further, Panel A in Figure 1 shows a downward trend for all three financial
ratios.
In Panel B, we report a correlation matrix between variables. It is interesting to note
that all financial ratios are positively and closely correlated, but they are weakly and
negatively correlated with excess returns.
13
In Panel C, we report summary statistics and unit-
root tests for the cyclical and stochastic trend components. Not surprisingly, autocorrelations
of the cyclical components of financial ratios are lower than those of financial ratios. The null
hypothesis of unit root in the cyclical components is rejected at conventional levels by both
the augmented Dickey-Fuller test and the Philips-Perron test. The low autocorrelation in the
cyclical components of financial ratios is very attractive in prediction regressions, since small-
sample bias in predictive regression is primarily due to highly persistent predictors. In
contrast, autocorrelations of the stochastic trend components of financial ratios are close to
one and the null hypothesis of unit root in the trend components is not rejected at
conventional levels by the Philips-Perron test.
In Panel D, we report a correlation matrix between excess returns (or CAY, RTB) and
cyclical components of financial ratios. As in Panel B, the cyclical components of financial
ratios are closely and positively correlated with each other. In contrast, the cyclical
components are also highly and negatively correlated with excess returns. The correlations
between the cyclical components of DP, EP, and BP and excess returns are -0.36, -0.35, and
-0.36, respectively. They are much stronger in their absolute value than the correlations
between excess returns and both CAY and RTB (-0.006 and -0.175, respectively). Panel B in
Figure 1 shows that there is no trend for all three cyclical components of financial ratios. In
sum, the cyclical components of financial ratios are less persistent and more closely correlated
with excess returns. In Panel E, we find that the stochastic trend components of financial
ratios are also associated with excess returns: the correlation between excess returns and the
stochastic trend components of dividend-price ratio, earning-price ratio and book-to-market
are -0.23, -0.23, and -0.24, respectively. The absolute values of these correlations are also
much higher than the correlations between excess returns and both CAY and RTB.

12
This evidence is consistent with the finding of Campbell and Shiller (1987), Froot and Obstfeld (1991), Jiang
and Lee (2007), among others. The null hypothesis of unit root in EP is marginally rejected.
13
This is consistent with the findings in the return prediction literature that CAY and RTB have more predictive
power than financial ratios (see Lettau and Ludvigson, 2001, 2005; Ang and Bekaert, 2007).
14

3. Long-horizon Prediction

We examine three issues in this section: (i) Are excess returns or fundamentals predictable?
(ii) Between the cyclical component and the stochastic trend component, which component
predicts excess returns and fundamentals growth? (iii) What is the mechanism (channel) of
the prediction, if there is any?

3.1 Prediction of returns
Theoretical models in (8), (9), and (10) imply that financial ratios (DP, EP, and BP) predict
either stock returns or fundamentals. Here, we investigate empirically whether financial
ratios predict excess returns in various horizons. First, we examine this relation based on
univariate regressions. In Table 2, we report estimation results of the regression of log excess
returns on lagged financial ratios (DP, EP, and BP). We provide Newey-West corrected
standard errors in parentheses and adjusted R
2
statistics in squared brackets. The sample
period in panel A is from the first quarter of 1926 to the fourth quarter of 2008. The table also
reports the estimation results on two sub-sample periods from 1926:Q1 to 1951:Q4 in Panel B
and from 1952:Q1 to 2008:Q4 in Panel C.
From Table 2, we make the following observations. First, financial ratios significantly
and positively predict long-horizon returns but weakly predict short-horizon returns. Lettau
and Ludvigson (2001, 2005) provide similar evidence. Second, t-statistics and adjusted R
2

tend to increase as the prediction horizon increases. Third, the coefficients are sensitive to
sample periods (see also Lettau and Nieuwerburgh, 2008). The predictive power in the first
sub-sample period is much stronger than that in the second sub-sample period.
Now, we decompose financial ratios (DP, EP, and BP) into a cyclical component and a
stochastic trend component using the Kalman filter method recommended by Hodrick and
Prescott (1997). In Table 3, we report the estimation results of prediction regressions using
each component and both components. Since the stochastic tend is highly persistent, we use
the first difference (dG) of the stochastic tend in the regression. We report OLS estimates of
regressors, Newey-West corrected standard errors, and bootstrapping errors.
15
We find that each component of financial ratios predicts future excess returns
significantly. The cyclical components predict future excess returns with a positive
coefficient. The adjusted R
2
s increase monotonically as the prediction horizon increases and
reach the highest level at the prediction horizon of 16 quarters for C
DP
, and 12 quarters for C
EP

and C
BP
, respectively. The adjusted R
2
s are 30%, 53%, and 52% for C
DP
, C
EP
, and C
BP
,
respectively, at the peak. The coefficients and R
2
s in regressions of future returns on the
cyclical components increase in proportion to horizons of eight quarters (two years). This
implies that the variation in the cyclical components contains similar variation in expected
returns up to eight quarters. The coefficients and R2s in the regressions increase at a decaying
rate for longer return horizons, which suggests that the cyclical components contains less
variation in longer horizons. This pattern suggests that the cyclical components are associated
with the expected return with a mean-reverting component around a business-cycle-length.
14

The stochastic trend components predict future excess returns with a negative
coefficient. The bootstrapping errors show that the stochastic trend components are able to
forecast future stock returns but not one-quarter-ahead future returns. It suggests that the
stochastic trend components tend to forecast long horizon future stock returns. To our
knowledge, this is new evidence. Previous research assumes that the long-run stochastic trend
is constant and tends to ignore its predictive power. The HP filter allows us to generate the
time-varying long-run stochastic trend component. The negative sign of the coefficients of
the stochastic trend components is mainly due to the highly persistent expected return. The
adjusted R
2
s are 16%, 17%, and 25% at the 16 quarter horizon for the stochastic trend
components of DP, EP, and BP, respectively.
A similar observation is made when we use both cyclical and stochastic trend
components as predictors. The adjusted R
2
s of two components for DP, EP, and BP at the
one-quarter horizon are 5%, 13% and 13%, respectively, which are much higher than those of
raw financial ratios in Table 2, which are 1%, 2%, and 2%, respectively. The adjusted R
2
s
increase monotonically as the prediction horizon increases and reach the highest level at the
horizon of around twelve quarters. The adjusted R
2
s fall as the prediction horizon increases
beyond twelve or sixteen quarters. These adjusted R
2
s are substantially high relative to the

14
Fama and French (1987, 1988), and Summers (1986) show that the expected return is highly autocorrelated
with a long-run slow mean-reverting.
16
findings in previous studies.
15
This pattern of the adjusted R
2
is another new finding.
Previous studies show that the adjusted R
2
tends to increase as the horizon increases (e.g.,
Campbell, Lo, and MacKinlay, 1997; Cochrane, 2001). It is interesting to note that the
predictive power of the cyclical and stochastic trend components of financial ratios is at its
best over the horizon of three to four years, which is similar to the duration of business cycles.
Lettau and Ludvigson (2001, 2005) demonstrate that CAY has a strong predictive
power for excess returns at business cycle frequencies, showing direct linkage that risk premia
vary counter cyclically.
16
Ang and Bekaert (2007) provide evidence that the dividend-price
ratio has little predictive power for future excess returns at long horizons. At short horizons,
the dividend-price ratio is able to predict future excess returns only with short rates. They
claim that the strongest predictive power comes from the short rate rather than from the
dividend yield.
A natural question is whether each variable has independent information about future
excess returns. To address this question, in Table 4 we report the results of the comparisons
using the two components of financial ratios, CAY and the relative T-bill rate for the sample
period from 1952:Q1 to 2008:Q4. The cyclical component (C) and the stochastic trend
component (dG) exhibit a similar predictive pattern as in Table 3. For example, at the one-
quarter horizon, the cyclical components of DP, EP, and BP predict excess returns
significantly. Both Newey-West corrected t-statistics and bootstrapping t-statistics are all
significant at the 1% level. The adjusted R
2
s are 8% for the cyclical components and around
5% for the stochastic trend components in one quarter horizon. The predictive power reaches
its peak at eight (sixteen) quarter horizon for the cyclical (stochastic trend) components of
financial ratios.
We also confirm the findings of Lettau and Ludvigson (2001, 2005) and Ang and
Bekaert (2007) that CAY predicts an increase in excess returns, especially at long horizons,
and RTB predicts a decline in excess returns at short horizons. The adjusted R
2
s of CAY
(RTB) at prediction horizons of 1, 2, 3, 4, 8, 12, 16, and 20 quarters are 4% (2%), 8% (2%),
11% (3%), 14% (4%), 23% (1%), 30% (1%), 32% (1%), and 31% (1%), respectively. It is

15
Lettau and Nieuwerburgh (2008) report the adjusted R
2
of 25% for prediction regression of excess returns on
dividend-price ratio with three breaks using annual data.
16
Idiosyncratic volatility has also been found associated with expected returns, see Goyal and Santa-Clara
(2003), Ang, Hodrick, Xing, and Zhang (2006), Jiang and Lee (2006).
17
interesting to note that the adjusted R
2
s at the one-quarter horizon are 4% and 2% for CAY
and RTB, respectively, which are much higher than those in the raw financial ratios but much
lower than (similar to) those of cyclical (stochastic trend) components of financial ratios.
It is also interesting to note that when we run the multivariate regression of excess
returns on cyclical component, stochastic trend component, CAY, and RTB, the coefficient of
CAY at the one-quarter horizon decreases from 1.03 to -0.49, and it becomes no longer
significant, while the coefficients of both cyclical and stochastic trend components of
financial ratios change little, and their t-statistics remain highly significant. The coefficient of
RTB also decreases in its absolute value, and it becomes insignificant. At long horizons, we
observe a similar pattern. This implies that the predictive power of CAY and RTB is captured
by the cyclical and stochastic trend components of financial ratios. In the subsample period
from 1952:Q1 to 2008:Q4, our evidence shows that at horizons from one to twelve quarters,
the cyclical components of financial ratios dominate predictive power. At horizons beyond
twelve quarters, the stochastic trend components of financial ratios dominate the predictive
power. The components of financial ratios outperform CAY and RTB in all horizons.

3.2 Prediction of fundamentals
The present value models in (8), (9), and (10) also imply that financial ratios (DP, EP, and BP)
may predict fundamentals. However, empirical evidence suggests that financial ratios have
little predictive power for fundaments (see Campbell, 1991; Lettau and Ludvigson, 2001,
2005; Campbell and Shiller, 2005).
17
Cochrane (2001, p. 398) points out:
It is nonetheless an uncomfortable fact that almost all variation in price/dividend ratios is due to
variation in expected excess returns. How nice it would be if high prices reflected expectations of
higher future cash flows. Alas, that seems not to be the case.
Here, we investigate whether the decomposed financial ratios predict such
fundamentals as log dividend growth (DD), log earnings growth (EE), and log accounting

17
Ang and Bekaert (2007) find the marginal predictability of dividend growth using dividend-price ratio. Using
annual data, Lettau and Ludvigson (2005) find that dividend-price ratio significantly predicts dividend growth
but with the wrong (positive) sign. Ang and Bekaert (2007) find that earnings price ratio predicts future cash
flows.
18
returns (EB) in long horizons. Again, we choose these fundamentals based on the present
value models in (8), (9), and (10). The other reason to examine the prediction of
fundamentals is that it helps to understand the mechanism and driving forces of the return
prediction, which will be discussed later.
We present estimation results in Table 5. Consistent with the prediction of equation
(8), C
DP
significantly predict dividend growth, DD, with a negative coefficient up to twelve
quarters. From the one-quarter horizon to the twenty-quarter horizon, the adjusted R
2
s for
C
DP
are 25%, 32%, 33%, 30%, 11%, 3%, 1%, and 0%, respectively. The stochastic trend
component of DP does not have significant predictive power for dividend growth.
When we consider book-to-market (BP) model (equation (10)), the predictive pattern
is different from the pattern we observe from the dividend-price ratio model (equation (8)).
The cyclical component predicts negative coefficients of future accounting returns up to four
quarters while the stochastic trend component predicts long horizons accounting returns. As
for the predictive pattern of earnings-price (EP) model (equation (9)), the cyclical component
of EP predicts earnings growth in the horizons from two to five-years while the stochastic
trend component of EP does not have a significant predictive power for earnings growth. In
the prediction of excess returns, all financial ratios exhibit a similar prediction pattern. In
contrast, in the prediction of fundamentals, financial ratios exhibit different prediction
patterns.
Lettau and Ludvigson (2001, 2005) document that there is a common variation
between expected returns and expected dividend growth, which offsets the predictive power
of dividend yield, but not of the consumption-wealth ratio (CAY). As a robustness check, we
investigate the prediction of fundamentals using the data from 1952:1 to 2008:4. We also
compare the predictive power using multivariate regressions incorporating the two
components of financial ratios, CAY, and RTB. Table 6 reports the results. When the
dependent variable is dividend growth and the predictor is the cyclical component of the
dividend-price ratio, we find that the cyclical component of the dividend-price ratio predicts
dividend growth with a significant negative coefficient up to three quarters. However, the
stochastic trend component of the dividend-price ratio predicts dividend growth with a
positive coefficient. Our evidence helps explain why the dividend price ratio does not predict
dividend growth. Lettau and Ludvigson (2005) argue that the failure of dividend price ratio to
19
predict dividend growth is due to the positive correlation between expected return and
expected dividend growth, suggesting that time-varying investment opportunities are poorly
captured by dividend price ratio. Our evidence suggests that these investment opportunities
are captured separately by each components of dividend price ratio, and the failure of
dividend price ratio to predict dividend growth is due to the offsetting effect between the
cyclical and stochastic trend components. CAY does not predict dividend growth in
univariate regression, while RTB seems to predict dividend growth at short horizons.
When the dependent variable is earnings growth (EE), the cyclical component of the
earnings-price ratio predicts earnings growth with a positive coefficient at long horizons. The
stochastic trend component of the earnings-price ratio alone does not predict earnings growth.
When the dependent variable is accounting returns, we find that the cyclical component of
book-to-market seems to predict accounting returns negatively in short horizons while
positively in long horizons, while the stochastic trend component of book-to-market predicts
accounting returns with a positive coefficient, especially in long horizons beyond sixteen
quarters.

3.3 Further robustness check
The above analysis shows that the cyclical component and the stochastic trend component of
financial ratios predict both excess returns and fundamentals. From the econometric
viewpoint, the cyclical components are attractive because they are stationary and less subject
to small-sample bias criticism. However, there is a potential econometric problem with using
the stochastic trend components as predictors due to their highly persistent nature (e.g.,
Stambaugh 1986, 1999; Lewellen 2004). We provide bootstrapping errors for prediction
regressions to mitigate this problem.
To further address this concern, we apply Lewellens (2004) bias-corrected method for an
additional robustness check. We choose the Lewellen method because it is especially
designed for small sample bias correction, and the simulation results (Amihud, Hurvich, and
Wang, 2005) show that Lewellens method performs very well when the true value of the
autocorrelation of the predictor is near unity.
20
Lewellen (2004) proposes a testing method based on the empirical observation that the
autoregressive coefficient of the predictive variable is close to unity for some financial
ratios. Lewellens procedure is as follows.
1) Run the OLS regressions
1 t t t
r x

= + + , (12)
t t t
x x + + =


1
, and (13)
t t t
+ =

. (14)
2) Calculate the bias-corrected beta as
) ( =

L
. (15)
Since ) (

is unknown, a lower bound of 1 is assumed, which provides an upper

bound on the bias in the OLS beta.
3) Estimate the variance of
L

as
1
) 2 , 2 (
2 2
) ' (


=

X X
L
, and then calculate the t-
statistic as the ratio of
L

to the square root of

2
L

.
Lewellens bias-corrected forecast is reported in Table 7. It shows that the cyclical
(stochastic trend) components of financial ratios still predict stock returns with a significant
positive (negative) coefficient after Lewellens (2004) bias correction, except for the cyclical
component of DP at one-quarter horizon. In the prediction of fundamentals, the cyclical
components of DP significantly predict a decrease in dividend growth in all horizons while
the stochastic trend components of DP do not predict dividend growth. The cyclical
components and stochastic components for both EP and BP seem to predict earnings growth
and accounting returns, respectively. Overall, Table 7 confirms the predictive power of the
decomposed financial ratios in Tables 3 and 5.

3.4 Behavior of financial ratios
So far, we observe that the decomposed financial ratios (DP, EP, and BP) predict stock
returns. A natural question to ask is how financial ratios predict excess returns. Or what are
the channels of the prediction? Summers (1986), Fama and French (1988), and Campbell and
21
Shiller (1989, 2005) suggest a simple theory of slow mean reversion to explain the
predictability. That is, stock prices cannot drift too far from their fundamentals (dividend,
earnings, or book value). The theory of slow mean reversion requires that financial ratios
have to be stationary in the long run. The predictive power comes from the long-run mean
reversion in financial ratios. Previous findings also support that financial ratios have more
predictive power in long horizons.
We observe that the cyclical components of the financial ratios predict increases in
stock returns and decreases in fundamentals, while the stochastic trend components of the
financial ratios predict decreases in stock returns. Specifically, Tables 3 and 4 show that C
DP
predicts increases in excess returns. We find a similar pattern for the predictors C
EP
and C
BP
.
Particularly, the coefficients in the regressions increase at a slower rate for longer return
horizons (beyond twelve quarters). Tables 3, 4, and 7 show that stochastic trend components
of financial ratios predict decreases in stock returns. The negative sign indicates that the
discount rate effect is persistent. We interpret these findings as evidence of the cyclical
component reflecting a local mean reversion effect, while the stochastic trend component
reflecting a long-run persistence effect. So our findings suggest that the predictive powers of
financial ratios are through two channels: local mean reversion and long-run persistence
effects.
In particular, we find that the stochastic trend components are persistent and show a
higher R
2
s in long horizons. This indicates that the long-run persistence in the stochastic
trend components of financial ratios is particularly effective in long horizons. This helps
explain previous findings that raw financial ratios tend to show some predictive power for
stock returns in long horizons. In addition, our finding that the two components predict stock
returns in the opposite directions suggests that, in short horizons, the two components of
financial ratios tend to offset much of each others prediction. This helps explain the failure
of previous studies to find strong predictive power of raw financial ratios in short horizons in
the absence of decomposition.

4. Out-of-sample Prediction

22
Our in-sample prediction results are striking. However, since both components are estimated
using the full sample, there is a concern that it is possible that the results are subject to a
look-ahead bias. We address this concern by implementing out-of-sample (OOS)
predictions. The Hodrick-Prescott decomposition is based on the relative long-run equilibrium
relation. For a meaningful and consistent estimation, it requires a large number of
observations. On the other hand, the OOS prediction has to rely on the real-time data that
may induce sampling errors in forming the cyclical and stochastic trend components.
Therefore, we consider two types of OOS prediction. First, we predict OOS using the ex-post
decomposition (components are estimated by using the full sample). Second, we predict OOS
using alternative ex-ante decomposition. In this approach, we estimate the cyclical and
stochastic trend components using real-time data (available at the time of prediction). We call
the first approach pseudo OOS, and the second pure OOS.
18

We choose the random walk model as a benchmark model (restricted model). We
implement nested prediction comparisons. We run the prediction regression using data from
1926:Q1 to 1989:Q4, and thus the first period for prediction is 1990:Q1. We report the ratio
of the root mean squared errors for the unrestricted and restricted model forecasts, Theils U,
MSE-F (H
0
: restricted and unrestricted predictions are equal) by McCracken (2004), ENC-F
(H
0
: restricted prediction encompasses the unrestricted prediction) by Clark and McCracken
(2001), and pseudo R
2
measured as one minus the ratio of mean square error of unrestricted to
restricted models.
Table 8 reports the results for the pseudo OSS prediction with bootstrapping errors.
When the unrestricted models include raw financial ratios (DP, EP, and BP), we find that the
prediction errors in the restricted model are smaller than those in the unrestricted models.
Theils U is greater than one, and pseudo R
2
are negative. Both MSE-F and ENC-F show that
financial ratios do not perform well in OOS predictions. Our evidence is consistent with
evidence provided by Goyal and Welch (2008) and Lettau and Nieuwerburgh (2008) in that
the random walk model outperforms the models with raw financial ratios. We find a similar
pattern for the model with RTB as a predictor. We find that CAY with fixed cointegrating
parameters for the full sample outperforms the random walk model in Clark and McCracken
(2001) test.

18
We use the terms following Lettau and Nieuwergurgh (2007).
23
We are particularly interested in the OOS prediction with the cyclical or stochastic
trend component of financial ratios as a predictor. When we compare the performance of the
random walk model with that of the model with the ex-post cyclical component of financial
ratios, we find that the Theils U is less than one, and pseudo R
2
is positive for C
DP,
C
EP,
and
C
BP
. Both MSE-F and ENC-F are statistically significant with bootstrap. When we compare
the performance of the random walk model with that of the model with the ex-post stochastic
trend component of financial ratios, we find a similar pattern. Our evidence shows that the
models including the cyclical or stochastic trend components of financial ratios (estimated in
the full sample) in the restricted model have superior OOS predictions.
Table 9 reports the results for the pure OOS prediction. Here, we use twenty-five
years moving average of financial ratio as a measure of stochastic trend component while the
difference between the financial ratio and the stochastic trend as a measure of the cyclical
component. In this way, we use the cyclical and stochastic trend components estimated using
real time data in OOS prediction tests. We find that the Theils U is less than one for all
cyclical components of three financial ratios, suggesting that the mean squared errors (MSE)
for the unrestricted model is less than the MSE for the restricted model. MSE-F rejects the
null of equal forecast accuracy between the constant expected returns benchmark model and
the cyclical component-augmented model. ENC-F also rejects the null hypothesis that
cyclical components have no predictive power for excess returns. However, bootstrap errors
show that only the MSE-F and ENC-F for the cyclical component in earnings price ratio are
significant. For the stochastic trend components, the Theils U in dividend price ratio is less
than one while the others are greater than one. The bootstrap errors show that only the ENC-
F for the stochastic component of dividend price ratio is significant. In sum, the result shows
some of the cyclical components of financial ratios display statistically significant out-of-
sample predictive power for excess returns. The stochastic trend components display little
out-of-sample predictive power for excess returns. For the growth in fundamentals, both the
cyclical and stochastic trend components of book-to-market ratio show statistically significant
predictive power for accounting returns. The Theils U of the cyclical and stochastic trend
components are 0.845 and 0.843, respectively. MES-F and ENC-F are 30.500 and 19.782
(30.924 and 22.768), respectively, for the cyclical (stochastic trend) component. Bootstrap
errors also suggest the out-of-sample predictability.
24

5. Concluding Remarks

Cochrane (2008) points out, If both returns and dividend growth are unforecastable, then
present value logic implies that the price/dividend ratio is constant, which is obvious not.
Some explanation should be explored. Motivated by the finding that financial ratios are
highly persistent and that the mean of financial ratios is time-varying, we have examined the
prediction of excess returns and fundamentals by financial ratios in-sample and out-of-sample.
We examine the prediction by decomposing the financial ratios into a cyclical component and
a stochastic trend component using Hodrick and Prescotts Kalman filter procedure. Previous
studies find that financial ratios predict long-horizon returns but little of short-horizon returns
and fundamentals. In contrast, we find that decomposed financial ratios significantly predict
excess returns and fundamentals in both long and short horizons. The out-of-sample forecast
result shows that the cyclical component of earnings price ratio is superior in forecasting
market return, and the stochastic trend component of book-to-market ratio is superior in
forecasting fundamentals.
We further find that the cyclical components of financial ratios predict increases in
returns, while the stochastic trend components predict decreases in returns. We interpret these
findings as evidence that the cyclical components reflect a local mean reversion effect while
the stochastic trend components reflect a long-run persistence effect. This helps explain
previous findings that, in the absence of decomposition, financial ratios find little predictive
power in short horizons due to offsetting effects. It also helps explain the failure of dividend
price ratio to predict dividend growth. Our result shows that the decomposed financial ratios
based on Hodrick and Prescott method predict stock returns and fundamentals better than
financial ratios alone.

25
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29
Figure 1. Financial ratios (DP, EP, and BP) and their cyclical components and stochastic
trend components with NBER business cycles.

Panel A:


Panel B:


Panel C:
Long-run expected value of stochstic trend components of financial ratios
DP EP BP
1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
-5
-4
-3
-2
-1
0
1
30
Table 1
Summary statistics
This table reports summary statistics for the financial ratios (log dividend-price ratio (DP), log earnings-price ratio
(EP), and log book-to-market ratio (BP)) and their cyclical components (C
DP,
C
EP
, and C
BP
) and stochastic trend
component (G
DP,
G
EP,
and G
BP
), consumption-wealth ratio (CAY), relative T-bill rates (RTB), and log excess
returns (R). is the first order autocorrelation. ADF and PP denote the augmented Dickey-Fuller test and the
Philips-Perron test with 4 lags. The critical values for ADF and PP are: 1%, -3.453; 5%, -2.871; and 10%, -2.572,
respectively. *, **, and *** represent significance at 10%, 5% and 1% levels, respectively.

Panel A: Summary statistics and unit root tests for return and ratios
Series Sample period Mean Std ADF PP
R 1926:Q1-2008:Q4 0.014 0.099 -0.059 -8.161*** -19.018***
DP 1926:Q1-2008:Q4 -3.325 0.455 0.974 -2.558 -2.418
EP 1926:Q1-2008:Q4 -2.912 0.379 0.965 -3.000** -2.751*
BP 1926:Q1-2008:Q4 -0.349 0.468 0.977 -2.335 -2.147
CAY 1951:Q2-2008:Q4 0.000 0.014 0.882 -2.732* -3.513***
RTB 1926:Q1-2008:Q4 0.000 0.002 0.714 -7.221*** -7.475***
Panel B: Correlation matrix for returns and ratios
R DP EP BP CAY RTB
R 1.00 -0.044 -0.097 -0.094 -0.006 -0.175
DP 1.00 0.952 0.963 0.162 0.033
EP 1.00 0.992 0.086 -0.005
BP 1.00 0.064 0.006
CAY 1.00 -0.161
RTB 1.00
Panel C: Summary statistics and unit root tests for cyclical and trend components
Series Sample period Mean Std ADF PP
C
DP
1926:Q1-2008:Q4 0.000 0.174 0.827 -7.438*** -6.146***
C
EP
1926:Q1-2008:Q4 0.000 0.169 0.827 -7.236*** -6.198***
C
BP
1926:Q1-2008:Q4 0.000 0.164 0.818 -7.198*** -6.231***
G
DP
1926:Q1-2008:Q4 -3.324 0.408 1.000 -2.030 0.027
G
EP
1926:Q1-2008:Q4 -2.912 0.326 0.999 -3.097** -0.455
G
BP
1926:Q1-2008:Q4 -0.349 0.429 1.000 -3.204** -0.337
Panel D: Correlation matrix for returns and cyclical components
R
C
DP
C
EP
C
BP

CAY RTB
R 1.00 -0.356 -0.353 -0.355 -0.006 -0.175
C
DP

1.000 0.943 0.952 0.381 -0.134

C
EP

1.000 0.995 0.371 -0.189

C
BP

1.000 0.387 -0.176

CAY

1.000 -0.161
RTB 1.000
Panel E: Correlation matrix for returns and trend components
R
G
DP
G
EP
G
BP

CAY RTB
R 1.00 -0.234 -0.227 -0.241 -0.006 -0.175
dG
DP

1.000 0.922 0.944 -0.587 0.059

dG
EP

1.000 0.970 -0.675 0.059

dG
BP

1.000 -0.608 0.042

CAY 1.000 -0.161
RTB 1.000
31
Table 2
Forecasting quarterly stock returns: Univariate regressions

This table reports estimates from regressions of excess stock returns on lagged financial ratios listed in the first
column. The dependent variable is the sum of H-period log excess returns on the S&P 500 Index over a 3-month
T-bill rate. Financial ratios are log dividend-price ratio (DP), log earnings-price ratio (EP), and log book-to-
market (BP), respectively. They are all from the S&P500 Index. For each regression, the table reports OLS
estimates of regressors, Newey-West corrected standard errors in parentheses, and adjusted R
2
statistics in
squared brackets. The sample period is from 1926:1 to 2008:4. The table also reports the results on the two
sub-sample periods: 1926:Q1 1951:Q4, and 1952:Q1 2008:Q4.

Forecast horizon H (quarters)
Ratio 1 2 3 4 8 12 16 20
Panel A:1926:1-2008:4
DP
0.02 0.04 0.07 0.10 0.19 0.27 0.34 0.4

(0.02) (0.02) (0.02) (0.03) (0.03) (0.04) (0.04) (0.04)

[0.01] [0.02] [0.03] [0.04] [0.09] [0.12] [0.16] [0.20]
EP
0.04 0.07 0.11 0.16 0.30 0.40 0.47 0.51

(0.02) (0.03) (0.03) (0.03) (0.04) (0.05) (0.05) (0.05)

[0.02] [0.04] [0.06] [0.09] [0.15] [0.19] [0.21] [0.21]
BP
0.03 0.05 0.08 0.11 0.21 0.29 0.36 0.41

(0.02) (0.02) (0.02) (0.03) (0.03) (0.04) (0.04) (0.04)

[0.02] [0.03] [0.05] [0.06] [0.12] [0.16] [0.19] [0.20]
Panel B:1926:1-1951:4
DP
0.05 0.07 0.15 0.26 0.61 0.91 1.19 1.28

(0.09) (0.08) (0.08) (0.11) (0.09) (0.15) (0.13) (0.12)

[0.00] [0.00] [0.02] [0.06] [0.19] [0.30] [0.43] [0.46]
EP
0.11 0.18 0.30 0.43 0.84 1.14 1.28 1.15

(0.08) (0.08) (0.07) (0.08) (0.12) (0.14) (0.11) (0.12)

[0.05] [0.09] [0.15] [0.22] [0.42] [0.55] [0.57] [0.43]
BP
0.10 0.16 0.27 0.39 0.78 1.11 1.33 1.32

(0.07) (0.06) (0.07) (0.08) (0.11) (0.10) (0.07) (0.07)

[0.04] [0.08] [0.14] [0.20] [0.42] [0.61] [0.72] [0.65]
Panel C:1952:1-2008:4
DP
0.03 0.05 0.08 0.10 0.18 0.24 0.28 0.35

(0.01) (0.02) (0.02) (0.03) (0.04) (0.04) (0.04) (0.04)

[0.01] [0.03] [0.05] [0.06] [0.11] [0.14] [0.15] [0.18]
EP
0.03 0.06 0.08 0.11 0.19 0.25 0.29 0.36

(0.01) (0.02) (0.03) (0.03) (0.05) (0.06) (0.05) (0.05)

[0.01] [0.03] [0.04] [0.05] [0.09] [0.11] [0.12] [0.15]
BP
0.03 0.06 0.08 0.11 0.20 0.26 0.31 0.37

(0.01) (0.02) (0.03) (0.03) (0.05) (0.05) (0.05) (0.05)

[0.01] [0.03] [0.04] [0.06] [0.10] [0.13] [0.14] [0.16]

32
Table 3
Forecasting quarterly stock returns: Decomposition regressions (1926:1-2008:4)

This table reports estimates from regressions of excess stock returns on the lagged decomposed financial ratios.
The dependent variable is the sum of H-period log excess returns on the S&P 500 Index over a 3-month T-bill
rate. Financial ratios are log dividend-price ratio (DP), log earnings-price ratio (EP), and log book-to-market
(BP), respectively. They are all from the S&P500 Index. C and dG are the cyclical and stochastic growth rate
(the first difference of trend component) components of financial ratios. The table reports OLS estimates of
regressors, Newey-West corrected standard errors (in parentheses), bootstrapping errors (in bracket) and adjusted
R
2
statistics. The sample period is from 1926:1 to 2008:4.

H C
DP
dG
DP
R
2
C
EP
dG
EP
R
2
C
BP
dG
BP
R
2

1 0.10 0.03 0.18 0.09 0.19 0.09
(0.07) (0.07) (0.07)
[0.03] [0.03] [0.03]
1.42 0.02 1.59 0.03 1.50 0.04
(0.40) (0.63) (0.57)
[0.87] [1.24] [1.30]
0.10 1.43 0.05 0.18 1.63 0.13 0.19 1.52 0.13
(0.07) (0.40) (0.07) (0.60) (0.07) (0.54)
[0.03] [0.92] [0.03] [1.35] [0.04] [1.42]
2 0.19 0.05 0.33 0.17 0.34 0.16
(0.07) (0.06) (0.06)
[0.04] [0.05] [0.05]
2.71 0.05 3.05 0.07 2.89 0.07
(0.56) (0.76) (0.69)
[1.17] [1.73] [1.75]
0.19 2.71 0.11 0.34 3.11 0.24 0.34 2.92 0.24
(0.07) (0.54) (0.06) (0.72) (0.06) (0.64)
[0.05] [1.28] [0.05] [1.79] [0.05] [1.84]
3 0.31 0.10 0.51 0.25 0.52 0.25
(0.07) (0.06) (0.06)
[0.06] [0.06] [0.06]
3.92 0.07 4.41 0.09 4.19 0.10
(0.70) (0.98) (0.88)
[1.49] [2.15] [2.30]
0.31 3.93 0.17 0.52 4.50 0.35 0.53 4.24 0.35
(0.07) (0.67) (0.06) (0.88) (0.06) (0.77)
[0.06] [1.52] [0.06] [2.21] [0.06] [2.32]
4 0.46 0.15 0.71 0.34 0.73 0.34
(0.09) (0.06) (0.06)
[0.07] [0.07] [0.07]
5.11 0.08 5.69 0.10 5.44 0.12
(0.84) (1.18) (1.06)
[1.77] [2.57] [2.71]
0.46 5.11 0.23 0.72 5.81 0.46 0.73 5.51 0.46
(0.08) (0.78) (0.06) (0.99) (0.06) (0.86)
[0.07] [1.86] [0.07] [2.68] [0.07] [2.79]
8 0.85 0.26 1.22 0.52 1.25 0.51
(0.08) (0.11) (0.11)
33
[0.10] [0.10] [0.10]
9.06 0.13 9.65 0.15 9.57 0.18
(1.31) (1.69) (1.51)
[2.76] [3.90] [4.01]
0.86 9.23 0.39 1.24 10.07 0.69 1.27 9.88 0.71
(0.07) (1.07) (0.08) (0.96) (0.07) (0.83)
[0.10] [2.72] [0.10] [3.97] [0.10] [4.10]
12 1.05 0.29 1.45 0.53 1.49 0.52
(0.13) (0.14) (0.14)
[0.11] [0.12] [0.12]
11.96 0.15 12.14 0.17 12.58 0.23
(1.59) (1.80) (1.66)
[3.64] [4.82] [5.02]
1.07 12.22 0.45 1.48 12.75 0.72 1.52 13.05 0.77
(0.11) (1.21) (0.09) (0.84) (0.08) (0.77)
[0.12] [3.73] [0.12] [5.03] [0.12] [5.14]
16 1.17 0.30 1.47 0.44 1.52 0.45
(0.11) (0.10) (0.10)
[0.13] [0.13] [0.13]
13.56 0.16 13.54 0.17 14.69 0.25
(1.78) (1.95) (1.83)
[4.44] [5.46] [5.78]
1.18 13.86 0.46 1.50 14.18 0.64 1.55 15.19 0.72
(0.10) (1.42) (0.07) (0.92) (0.08) (0.91)
[0.13] [4.49] [0.14] [5.67] [0.14] [5.92]
20 1.23 0.28 1.33 0.32 1.41 0.33
(0.10) (0.11) (0.11)
[0.13] [0.14] [0.14]
13.70 0.13 14.26 0.16 16.04 0.26
(2.03) (2.10) (1.96)
[5.14] [5.67] [6.37]
1.24 14.01 0.43 1.36 14.80 0.50 1.44 16.48 0.60
(0.09) (1.66) (0.08) (1.29) (0.08) (1.26)
[0.14] [5.08] [0.14] [6.01] [0.15] [6.50]



34
Table 4
Forecasting quarterly stock returns: Decomposition regressions (1952:1-2008:4)

This table reports estimates from regressions of excess stock returns on the lagged decomposed financial ratios.
The dependent variable is the sum of H-period log excess returns on the S&P 500 Index over a 3-month T-bill
rate. Financial ratios are log dividend-price ratio (DP), log earnings-price ratio (EP), and log book-to-market
(BP), respectively. They are all from the S&P500 Index. C and dG are the cyclical and the growth rate (the first
difference of trend component) components of financial ratios. The table reports OLS estimates of regressors,
Newey-West corrected t-statistics (in parentheses), bootstrapping errors (in bracket) and adjusted R
2
statistics.
Significant coefficients at the five percent level are highlighted in bold. The sample period is from 1952:1 to
2008:4.

h C
DP
dG
DP
CAY

RTB

R
2

C
EP
dG
EP
CAY RTB R
2
C
BP
dG
BP
CAY RTB R
2
1 0.19 0.08 0.19 0.08 0.19 0.08
(0.05) (0.05) (0.05)
[0.04] [0.04] [0.04]
1.30 0.05 1.40 0.05 1.39 0.05
(0.37) (0.45) (0.42)
[0.46] [0.81] [0.53]
1.03 0.04 1.03 0.04 1.03 0.04
(0.27) (0.27) (0.27)
[0.37] [0.37] [0.37]
3.77 0.02 3.77 0.02 3.77 0.02
(1.83) (1.83) (1.83)
[1.81] [1.80] [1.82]
0.21 1.55 0.49 2.73 0.13 0.22 1.96 0.76 2.38 0.13 0.21 1.83 0.68 2.58 0.13
(0.06) (0.56) (0.48) (1.69) (0.05) (0.75) (0.57) (1.67) (0.05) (0.64) (0.52) (1.66)
[0.07] [0.66] [0.61] [2.36] [0.07] [1.26] [0.63] [2.41] [0.07] [0.74] [0.62] [2.38]
2 0.44 0.19 0.43 0.18 0.43 0.18
(0.06) (0.06) (0.06)
[0.07] [0.07] [0.07]
2.40 0.08 2.62 0.08 2.61 0.09
(0.54) (0.65) (0.61)
[0.70] [1.23] [0.79]
2.22 0.08 2.22 0.08 2.22 0.08
(0.41) (0.41) (0.41)
[0.55] [0.55] [0.55]
5.49 0.02 5.49 0.02 5.49 0.02
(2.95) (2.95) (2.95)
[2.69] [2.70] [2.69]
0.46 2.80 0.74 3.03 0.27 0.47 3.52 1.19 2.22 0.26 0.47 3.37 1.09 2.63 0.27
(0.06) (0.65) (0.54) (2.59) (0.07) (0.82) (0.60) (2.58) (0.07) (0.74) (0.57) (2.55)
[0.12] [1.06] [1.06] [3.88] [0.12] [1.99] [1.07] [4.02] [0.12] [1.16] [1.06] [3.96]
3 0.65 0.28 0.63 0.26 0.63 0.26
(0.06) (0.06) (0.06)
[0.08] [0.08] [0.09]
3.42 0.11 3.77 0.11 3.76 0.12
(0.64) (0.76) (0.73)
[0.85] [1.54] [0.98]
3.11 0.11 3.11 0.11 3.11 0.11
(0.51) (0.51) (0.51)
35
[0.69] [0.69] [0.67]
9.36 0.03 9.36 0.03 9.36 0.03
(3.72) (3.72) (3.72)
[3.29] [3.30] [3.30]
0.69 4.15 1.30 5.54 0.40 0.70 5.31 1.99 4.32 0.39 0.70 5.09 1.86 4.90 0.41
(0.06) (0.76) (0.64) (3.05) (0.07) (0.95) (0.72) (3.02) (0.07) (0.84) (0.66) (2.99)
[0.16] [1.35] [1.46] [5.34] [0.16] [2.63] [1.47] [5.30] [0.16] [1.51] [1.48] [5.31]
4 0.87 0.36 0.84 0.34 0.84 0.34
(0.07) (0.08) (0.08)
[0.10] [0.10] [0.10]
4.44 0.13 4.91 0.13 4.90 0.15
(0.75) (0.88) (0.85)
[0.99] [1.76] [1.17]
4.20 0.14 4.20 0.14 4.20 0.14
(0.63) (0.63) (0.63)
[0.80] [0.80] [0.81]
12.32 0.04 12.32 0.04 12.32 0.04
(4.50) (4.50) (4.50)
[3.84] [3.85] [3.85]
0.90 5.16 1.37 6.79 0.51 0.92 6.65 2.26 5.08 0.49 0.91 6.46 2.15 5.81 0.51
(0.06) (0.80) (0.68) (3.46) (0.07) (0.96) (0.73) (3.49) (0.07) (0.85) (0.65) (3.47)
[0.20] [1.65] [1.84] [6.62] [0.21] [3.52] [1.85] [6.75] [0.21] [1.83] [1.88] [6.68]
8 1.31 0.44 1.30 0.44 1.30 0.44
(0.11) (0.11) (0.11)
[0.14] [0.14] [0.14]
8.09 0.23 8.97 0.23 9.12 0.27
(1.01) (1.16) (1.14)
[1.44] [2.61] [1.62]
7.42 0.23 7.42 0.23 7.42 0.23
(0.86) (0.86) (0.86)
[1.13] [1.13] [1.13]
9.46 0.01 9.46 0.01 9.46 0.01
(4.58) (4.58) (4.58)
[5.33] [5.32] [5.33]
1.35 8.52 0.74 1.05 0.66 1.47 11.44 2.79 3.88 0.70 1.45

11.11 2.52 2.73 0.73

(0.11) (0.88) (0.84) (2.82) (0.10) (1.13) (0.96) (2.81) (0.09) (0.87) (0.79) (2.81)
[0.31] [2.67] [2.90] [10.11] [0.33] [5.65] [3.09] [10.42] [0.33] [2.93] [3.07] [10.45]
12 1.38 0.36 1.39 0.37 1.40 0.38
(0.14) (0.14) (0.14)
[0.16] [0.16] [0.16]
10.94 0.29 12.29 0.31

12.52 0.36
(1.16) (1.19) (1.18)
[1.88] [3.23] [2.03]
9.97 0.30 9.97 0.30 9.97 0.30
(0.98) (0.98) (0.98)
[1.35] [1.32] [1.33]
9.15 0.01 9.15 0.01 9.15 0.01
(4.49) (4.49) (4.49)
36
[6.08] [6.10] [6.09]
1.32 9.74 1.40 2.49 0.66 1.54 13.82 1.73 5.70 0.74 1.52

13.41 1.28 4.31 0.77

(0.11) (1.07) (0.96) (2.73) (0.10) (1.13) (1.01) (2.72) (0.08) (0.84) (0.80) (2.70)
[0.37] [3.72] [3.55] [11.90] [0.40] [7.65] [3.85] [12.62] [0.41] [3.98] [3.89] [12.55]
16 1.27 0.26 1.33 0.29 1.35 0.29
(0.16) (0.15) (0.15)
[0.18] [0.18] [0.18]
12.82 0.32 14.84 0.38

15.03 0.43
(1.36) (1.24) (1.20)
[2.30] [3.76] [2.34]
11.70 0.32 11.70 0.32 11.70 0.32
(1.04) (1.04) (1.04)
[1.50] [1.48] [1.49]
10.21 0.01 10.21 0.01 10.21 0.01
(5.72) (5.72) (5.72)
[6.80] [6.73] [6.79]
1.10 10.30 3.50 0.66 0.59 1.44 15.54 0.83 4.17 0.70 1.42

15.11 0.20 2.58 0.75

(0.12) (1.38) (1.12) (3.16) (0.10) (1.35) (1.15) (2.83) (0.10) (1.02) (0.90) (2.70)
[0.41] [4.74] [4.00] [12.83] [0.45] [9.04] [4.43] [14.02] [0.46] [4.53] [4.49] [13.90]
20 1.50 0.29 1.51 0.29 1.53 0.30
(0.17) (0.17) (0.17)
[0.20] [0.20] [0.20]
14.25 0.30 16.99 0.38

17.24 0.43
(1.66) (1.44) (1.38)
[2.87] [4.35] [2.68]
13.08 0.31 13.08 0.31 13.08 0.31
(1.15) (1.15) (1.15)
[1.69] [1.67] [1.68]
14.10 0.01 14.10 0.01 14.10 0.01
(6.80) (6.80) (6.80)
[7.65] [7.61] [7.66]
1.34 12.04 3.29 2.10 0.60 1.65 18.49 1.91 1.70 0.70 1.62

17.98 1.04 0.14 0.75

(0.13) (1.54) (1.15) (3.82) (0.10) (1.31) (1.22) (3.28) (0.10) (0.99) (0.99) (3.18)
[0.47] [6.09] [4.57] [14.61] [0.51] [10.82] [5.05] [16.05] [0.53] [5.33] [5.20] [16.04]

37
Table 5
Forecasting quarterly fundamentals: Decomposition regressions (1926:1-2008:4)

This table reports estimates from regressions of fundamentals on the lagged decomposed financial ratios. The
dependent variable is the sum of H-period log dividend growth (DD), log earnings growth (EE), and log
accounting return (EB). Financial ratios are log dividend-price ratio (DP), log earnings-price ratio (EP), and log
book-to-market (BP), respectively. They are all from the S&P500 Index. C and dG are the cyclical and
stochastic growth rate (the first difference of trend component) components of financial ratios. The table reports
OLS estimates of regressors, Newey-West corrected t-statistics (in parentheses), bootstrapping errors (in bracket)
and adjusted R
2
statistics. The sample period is from 1926:1 to 2008:4.

Dependent variable: DD Dependent variable: EE Dependent variable: EB
H C
DP
dG
DP
R
2
C
EP
dG
EP
R
2
C
BP
dG
BP
R
2

1 0.10 0.25 0.05 0.01 0.04 0.04
(0.01) (0.03) (0.01)
[0.01] [0.03] [0.01]
0.17 0.00 1.31 0.03 0.47 0.05
(0.10) (0.49) (0.11)
[0.31] [1.13] [0.36]
0.10 0.18 0.25 0.05 1.30 0.03 0.03 0.47 0.09
(0.01) (0.10) (0.02) (0.49) (0.01) (0.10)
[0.01] [0.31] [0.03] [1.15] [0.01] [0.36]
2 0.20 0.32 0.05 0.00 0.07 0.04
(0.03) (0.05) (0.02)
[0.02] [0.05] [0.02]
0.31 0.00 2.23 0.03 0.97 0.05
(0.19) (0.73) (0.21)
[0.56] [1.75] [0.70]
0.20 0.31 0.32 0.05 2.22 0.03 0.07 0.96 0.10
(0.03) (0.18) (0.04) (0.73) (0.02) (0.20)
[0.02] [0.55] [0.05] [1.82] [0.02] [0.72]
3 0.28 0.33 0.01 0.00 0.10 0.04
(0.04) (0.07) (0.03)
[0.03] [0.07] [0.03]
0.40 0.00 3.07 0.03 1.50 0.06
(0.27) (0.97) (0.32)
[0.79] [2.37] [1.05]
0.28 0.41 0.33 0.00 3.07 0.03 0.10 1.49 0.10
(0.04) (0.27) (0.06) (0.97) (0.03) (0.30)
[0.03] [0.78] [0.07] [2.38] [0.03] [1.06]
4 0.34 0.30 0.09 0.00 0.12 0.03
(0.05) (0.09) (0.04)
[0.04] [0.08] [0.04]
0.46 0.00 3.79 0.04 2.06 0.06
(0.36) (1.20) (0.43)
[1.00] [2.84] [1.38]
0.34 0.46 0.30 0.10 3.81 0.04 0.12 2.04 0.10
(0.05) (0.36) (0.08) (1.19) (0.04) (0.41)
[0.04] [1.01] [0.08] [2.92] [0.04] [1.42]
8 0.34 0.11 0.61 0.09 0.13 0.01
38
(0.07) (0.15) (0.10)
[0.06] [0.11] [0.07]
0.27 0.00 5.46 0.03 4.60 0.09
(0.75) (1.93) (0.87)
[1.73] [4.27] [2.64]
0.34 0.34 0.11 0.62 5.67 0.13 0.12 4.57 0.09
(0.07) (0.76) (0.14) (1.75) (0.08) (0.86)
[0.06] [1.72] [0.12] [4.41] [0.07] [2.71]
12 0.24 0.03 0.95 0.17 0.03 0.00
(0.10) (0.16) (0.15)
[0.07] [0.13] [0.10]
0.33 0.00 5.79 0.03 7.55 0.11
(1.12) (2.42) (1.30)
[2.17] [5.23] [3.78]
0.24 0.27 0.03 0.96 6.18 0.20 0.02 7.54 0.11
(0.10) (1.15) (0.14) (1.97) (0.12) (1.29)
[0.07] [2.21] [0.14] [5.30] [0.10] [3.91]
16 0.16 0.01 0.92 0.14 0.06 0.00
(0.12) (0.18) (0.20)
[0.08] [0.15] [0.13]
1.13 0.00 5.46 0.02 10.75 0.14
(1.41) (2.64) (1.69)
[2.59] [5.59] [4.98]
0.16 1.09 0.01 0.94 5.87 0.16 0.08 10.77 0.14
(0.12) (1.44) (0.16) (2.13) (0.16) (1.68)
[0.08] [2.59] [0.15] [5.75] [0.13] [5.00]
20 0.07 0.00 0.81 0.10 0.12 0.00
(0.11) (0.17) (0.24)
[0.09] [0.15] [0.15]
1.97 0.00 4.77 0.01 14.07 0.16
(1.61) (2.63) (2.05)
[2.92] [5.73] [5.96]
0.07 1.95 0.00 0.82 5.10 0.12 0.14 14.12 0.17
(0.11) (1.63) (0.16) (2.19) (0.18) (2.04)
[0.09] [2.94] [0.15] [5.89] [0.16] [6.07]


39
Table 6
Forecasting quarterly fundamentals: Decomposition regressions (1952:1-2008:4)

This table reports estimates from regressions of fundamentals on the lagged decomposed financial ratios. The
dependent variable is the sum of H-period log dividend growth (DD), log earnings growth (EE), and log
accounting returns (EB). Financial ratios are log dividend-price ratio (DP), log earnings-price ratio (EP), and log
book-to-market ratio (BP), respectively. They are all from the S&P500 Index. C and dG are the cyclical and
stochastic growth rate (the first difference of trend component) components of financial ratios. The table reports
OLS estimates of regressors, Newey-West corrected t-statistics (in parentheses), bootstrapping errors (in bracket)
and adjusted R
2
statistics. The sample period is from 1952:1 to 2008:4.

Dependent variable: DD Dependent variable: EE Dependent variable: EB
h C
DP
dG
DP
CAY

RTB

R
2

C
EP
dG
EP
CAY RTB R
2
C
BP
dG
BP
CAY RTB R
2
1 0.02 0.02 0.06 0.00 0.04 0.06
(0.01) (0.05) (0.01)
[0.01] [0.05] [0.01]

0.23 0.04 0.78 0.01 0.01 0.00

(0.07) (0.68) (0.10)

[0.09] [1.02] [0.13]

0.11 0.01 0.44 0.00 0.23 0.03

(0.06) (0.35) (0.09)

[0.07] [0.47] [0.09]

1.64 0.10 7.39 0.05 3.66 0.33

(0.23) (2.40) (0.42)

[0.35] [2.27] [0.44]
0.01 0.29 0.17 1.57 0.15 0.01 2.22 1.59 7.09 0.07 0.01 0.17 0.15 3.47 0.35
(0.01) (0.11) (0.10) (0.24) (0.06) (1.57) (1.16) (2.17) (0.01) (0.12) (0.11) (0.41)
[0.01] [0.10] [0.08] [0.36] [0.06] [1.16] [0.56] [2.43] [0.01] [0.15] [0.11] [0.46]
2 0.04 0.02 0.01 0.00 0.07 0.05
(0.02) (0.07) (0.02)
[0.02] [0.08] [0.02]

0.49 0.06 0.95 0.00 0.06 0.00

(0.12) (0.91) (0.20)

[0.16] [1.42] [0.25]

0.17 0.00 0.10 0.00 0.40 0.02

(0.11) (0.57) (0.17)

[0.12] [0.65] [0.17]

3.02 0.12 10.18 0.04 7.22 0.34

(0.41) (4.57) (0.81)

[0.60] [3.15] [0.85]
0.01 0.66 0.42 2.89 0.20 0.01 1.80 0.78 10.60 0.04 0.01 0.23 0.20 6.92 0.36
(0.02) (0.17) (0.16) (0.43) (0.09) (1.26) (0.83) (4.88) (0.02) (0.19) (0.19) (0.83)
[0.02] [0.17] [0.14] [0.63] [0.10] [1.61] [0.79] [3.39] [0.03] [0.28] [0.21] [0.88]
3 0.05 0.02 0.04 0.00 0.10 0.05
(0.02) (0.12) (0.03)
[0.02] [0.11] [0.03]
40

0.76 0.08 1.02 0.00 0.13 0.00

(0.16) (1.14) (0.28)

[0.22] [1.89] [0.36]

0.27 0.01 0.20 0.00 0.59 0.02

(0.15) (0.69) (0.25)

[0.18] [0.86] [0.26]

4.18 0.12 6.80 0.01 10.21 0.32

(0.57) (5.42) (1.17)

[0.84] [4.17] [1.24]
0.01 0.96 0.56 3.93 0.20 0.01 2.10 1.09 7.55 0.01 0.01 0.32 0.29 9.77 0.33
(0.02) (0.23) (0.21) (0.61) (0.15) (2.05) (1.43) (5.65) (0.03) (0.29) (0.28) (1.20)
[0.02] [0.24] [0.21] [0.85] [0.12] [2.08] [1.04] [4.29] [0.04] [0.40] [0.31] [1.30]
4 0.05 0.01 0.21 0.01 0.12 0.04
(0.03) (0.16) (0.03)
[0.03] [0.13] [0.04]

1.03 0.09 0.98 0.00 0.23 0.00

(0.20) (1.33) (0.37)

[0.28] [2.26] [0.48]

0.31 0.01 1.04 0.00 0.68 0.02

(0.19) (1.00) (0.33)

[0.22] [1.03] [0.34]

4.80 0.09 2.25 0.00 12.37 0.27

(0.74) (4.13) (1.51)

[1.06] [4.97] [1.60]
0.01 1.35 0.76 4.39 0.19 0.01 1.14 0.25 0.46 0.00 0.01 0.32 0.29 11.90 0.28
(0.03) (0.28) (0.26) (0.78) (0.20) (2.00) (1.48) (4.68) (0.04) (0.40) (0.38) (1.57)
[0.03] [0.31] [0.26] [1.08] [0.15] [2.55] [1.25] [5.19] [0.05] [0.53] [0.41] [1.69]
8 0.02 0.00 0.76 0.09 0.08 0.00
(0.05) (0.21) (0.06)
[0.05] [0.17] [0.07]

2.17 0.14 0.19 0.00 0.72 0.00

(0.35) (1.74) (0.64)

[0.51] [3.34] [0.89]

0.33 0.00 2.76 0.02 0.84 0.01

(0.33) (1.66) (0.62)

[0.38] [1.44] [0.61]

3.22 0.01 31.32 0.10 14.66 0.12

(1.30) (5.49) (2.66)

[1.86] [6.90] [2.92]
0.01 2.95 1.39 2.43 0.16 0.01 2.17 1.49 27.16 0.15 0.01 0.03 0.31 14.32 0.11
(0.05) (0.46) (0.44) (1.24) (0.22) (1.95) (2.01) (5.18) (0.07) (0.79) (0.78) (2.75)
[0.05] [0.56] [0.46] [1.93] [0.20] [3.66] [1.74] [7.21] [0.09] [1.00] [0.73] [3.04]
12 0.09 0.01 0.94 0.11 0.13 0.00
(0.07) (0.19) (0.09)
41
[0.06] [0.20] [0.10]

3.34 0.18 1.98 0.00 1.32 0.01

(0.46) (1.88) (0.86)

[0.71] [3.74] [1.22]

0.41 0.00 4.00 0.03 0.16 0.00

(0.45) (1.63) (0.89)

[0.51] [1.61] [0.80]

0.08 0.00 39.60 0.13 11.16 0.04

(1.68) (7.54) (3.12)

[2.45] [7.55] [3.83]
0.01 4.49 1.77 0.83 0.21 0.01 7.43 5.58 34.88 0.25 0.01 1.28 0.43 11.95 0.05
(0.07) (0.60) (0.61) (1.47) (0.20) (1.81) (1.89) (7.12) (0.10) (1.07) (1.11) (3.20)
[0.07] [0.78] [0.61] [2.56] [0.22] [4.15] [1.84] [7.82] [0.12] [1.41] [0.98] [3.98]
16 0.06 0.00 0.86 0.09 0.34 0.04
(0.08) (0.18) (0.10)
[0.07] [0.20] [0.12]

4.49 0.23 3.91 0.02 2.26 0.02

(0.55) (1.98) (1.03)

[0.94] [3.89] [1.52]

0.73 0.00 4.54 0.04 1.24 0.00

(0.53) (1.56) (1.06)

[0.61] [1.63] [0.95]

2.25 0.00 38.34 0.12 6.49 0.01

(2.07) (7.44) (3.47)

[2.88] [7.66] [4.53]
0.01 6.01 2.19 3.42 0.27 0.01 12.23 9.62 34.57 0.29 0.01 4.01 2.81 8.59 0.09
(0.07) (0.61) (0.64) (1.78) (0.19) (1.82) (1.94) (6.62) (0.11) (1.21) (1.32) (3.50)
[0.08] [1.03] [0.73] [3.01] [0.23] [4.29] [1.95] [8.01] [0.13] [1.70] [1.13] [4.65]
20 0.05 0.00 0.53 0.04 0.46 0.07
(0.09) (0.16) (0.10)
[0.08] [0.19] [0.13]

5.44 0.26 5.38 0.04 3.62 0.04

(0.60) (1.94) (1.17)

[1.13] [3.91] [1.68]

1.10 0.01 3.74 0.02 2.74 0.03

(0.59) (1.65) (1.13)

[0.68] [1.58] [1.02]

3.82 0.00 31.68 0.09 4.05 0.00

(2.57) (7.28) (4.11)

[3.24] [7.42] [4.88]
0.01 7.05 2.52 5.59 0.31 0.01 14.72 11.32 30.38 0.27 0.01 7.51 6.05 6.94 0.20
(0.07) (0.64) (0.66) (2.10) (0.17) (1.63) (1.98) (5.99) (0.11) (1.26) (1.33) (3.91)
[0.10] [1.24] [0.82] [3.33] [0.22] [4.36] [1.90] [7.87] [0.15] [1.94] [1.26] [5.11]

42
Table 7
Lewellens (2004) bias-corrected forecast

This table reports Lewellens (2004) bias-corrected forecast for returns and fundamentals using stochastic
growth rate components of financial ratios. Financial ratios are log dividend-price ratio (DP), log earnings-price
ratio (EP), and log book-to-market (BP), respectively. They are all from the S&P500 Index. C and dG are the
cyclical and stochastic growth rate (the first difference of trend component) components of financial ratios. For
return (fundamentals) forecast, the dependent variable is the excess stock returns (dividend growth, earnings
growth, and accounting returns) in the different horizons. For the fundamentals forecast, the regressors are
chosen based on equations 8, 9 and 10. For example, we choose dividend-price ratio as a predictor when
fundamental is dividend growth. We report the Lewellens (2004) bias-corrected regression coefficient and t-
statistics (in parentheses). The sample period is from 1926:1 to 2008:4.


Return forecast

Fundamentals forecast
H
C
DP
C
EP
C
BP
C
DP
C
EP
C
BP

1 0.054 0.012 0.009 0.097 0.087 0.039
(7.744) (3.553) (2.639) (15.060) (4.459) (6.724)
2 0.050 0.195 0.196 0.205 0.089 0.075
(2.191) (9.085) (8.751) (18.929) (2.950) (6.507)
3 0.165 0.376 0.381 0.306 0.064 0.110
(5.475) (13.552) (13.137) (20.430) (1.586) (6.376)
4 0.315 0.585 0.595 0.383 0.014 0.139
(8.611) (17.866) (17.389) (20.359) (0.296) (6.072)
8 0.790 1.214 1.243 0.431 0.554 0.167
(14.663) (27.775) (27.169) (12.446) (8.098) (3.717)
12 1.012 1.483 1.524 0.320 0.984 0.069
(16.019) (28.957) (28.487) (6.909) (12.556) (1.055)
16 1.159 1.539 1.595 0.227 0.990 0.038
(16.394) (24.891) (24.931) (4.182) (11.539) (0.445)
20 1.235 1.413 1.487 0.131 0.900 0.110
(15.996) (19.027) (19.482) (2.197) (10.054) (1.073)
H
dG
DP
dG
EP
dG
BP
dG
DP
dG
EP
dG
BP

1 1.427 1.595 1.497 0.143 1.310 0.479
(2.416) (3.512) (3.422) (0.715) (3.102) (4.380)
2 2.699 3.055 2.880 0.254 2.225 0.979
(3.399) (5.054) (4.950) (0.720) (3.453) (4.515)
3 3.886 4.412 4.177 0.325 3.067 1.511
(3.916) (5.904) (5.818) (0.654) (3.591) (4.676)
4 5.032 5.686 5.413 0.353 3.791 2.075
(4.275) (6.488) (6.441) (0.566) (3.689) (4.846)
8 8.770 9.651 9.491 0.105 5.461 4.625
(5.604) (8.841) (9.246) (0.102) (3.700) (5.557)
12 11.430 12.141 12.462 0.503 5.790 7.576
(6.697) (10.775) (12.423) (0.386) (3.387) (6.278)
16 12.834 13.541 14.537 1.293 5.467 10.774
(7.272) (11.403) (14.921) (0.861) (2.989) (6.973)
20 12.859 14.261 15.885 2.106 4.776 14.098
(6.881) (10.514) (14.793) (1.286) (2.507) (7.601)

43
Table 8
Pseudo out-of sample forecast

This table reports the results of one-quarter-ahead nested prediction comparison of excess returns on the S&P
500 Index over a three-month T-bill rate and fundamentals. Financial ratios are log dividend-price ratio (DP),
log earnings-price ratio (EP), and log book-to-market (BP), respectively. They are all from the S&P500 Index.
C and dG are the cyclical and stochastic growth rate (the first difference of trend component) components of the
financial ratios. The table reports pseudo OOS prediction for CAY, RTB, C and dG. The benchmark (restricted)
model is the random walk model. We report the Theils U (the ratio of the root mean squared errors for the
unrestricted and restricted model forecasts), MSE-F (H
0
: restricted and unrestricted predictions are equal) by
McCracken (2004), ENC-F (H
0
: restricted prediction encompasses the unrestricted prediction) by Clark and
McCracken (2001), and pseudo R
2
measured as one minus the ratio of mean square error of unrestricted to
restricted models.

Return regression Fundamentals regression
Variable Theil U
MSE-F ENC-F
Pseudo
R
2
Theil U
MSE-F ENC-F
Pseudo
R
2
DP 1.014 2.117 1.218 0.029 1.958 47.309 2.545 2.834
[.010] [1.456] [.660] [.020] [.010] [1.230] [.639] [.020]
EP 1.050 7.016 1.198 0.102 1.016 1.984 0.183 0.032
[.010] [1.399] [.637] [.020] [.008] [1.031] [.542] [.017]
BP 1.027 3.895 1.059 0.054 0.867 21.212 51.344 0.249
[.011] [1.595] [.694] [.023] [.008] [1.032] [.573] [.016]
CAY 1.029 4.211 2.550 0.059

[.007] [1.079] [.571] [.014]

RTB 1.058 8.118 2.670 0.120

[.002] [.357] [.178] [.005]

C
DP
0.977 3.618 2.631 0.045 1.319 32.348 2.918 0.741
[.007] [1.052] [.545] [.014] [.007] [1.112] [.587] [.015]
C
EP
0.987 1.969 4.477 0.025 1.005 0.695 0.257 0.009
[.007] [1.047] [.526] [.014] [.009] [1.292] [.641] [.018]
C
BP
0.993 1.148 4.372 0.015 0.962 6.062 3.675 0.074
[.007] [1.012] [.517] [.014] [.006] [.976] [.524] [.013]
dG
DP
0.971 4.669 6.217 0.058 0.968 5.165 3.335 0.064

[.011] [1.596] [.953] [.022] [.013] [1.881] [1.063] [.026]
dG
EP
0.964 5.765 6.119 0.071 0.990 1.472 1.027 0.019

[.009] [1.353] [.736] [.018] [.013] [1.873] [1.043] [.027]
dG
BP
0.959 6.643 6.301 0.080 0.977 3.554 4.610 0.045
[.009] [1.396] [.813] [.019] [.009] [1.398] [.753] [.019]

44
Table 9
Pure out-of sample forecast

This table reports the results of one-quarter-ahead nested prediction comparison of excess returns on the S&P
500 Index over a three-month T-bill rate and fundamentals. Financial ratios are log dividend-price ratio (DP),
log earnings-price ratio (EP), and log book-to-market (BP), respectively. They are all from the S&P500 Index.
C and dG are the cyclical and stochastic growth rate (the first difference of trend component) components of the
financial ratios. Here, to avoid the look-ahead bias, we simply use 25 years moving average as a proxy for the
long-run growth component, the difference of the financial ratio series and the moving average as a proxy for the
cyclical component. The table reports pure OOS prediction for C and dG. The benchmark (restricted) model is
the random walk model. We report the Theils U (the ratio of the root mean squared errors for the unrestricted
and restricted model forecasts), MSE-F (H
0
: restricted and unrestricted predictions are equal) by McCracken
(2004), ENC-F (H
0
: restricted prediction encompasses the unrestricted prediction) by Clark and McCracken
(2001), and pseudo R
2
measured as one minus the ratio of mean square error of unrestricted to restricted models.



Return regression Fundamentals regression
Variable Theil U
MSE-F ENC-F
Pseudo
R
2
Theil U
MSE-F ENC-F
Pseudo
R
2
C
DP
0.986 2.249 2.056 0.029 1.495 42.017 3.481 1.236
[.015] [2.116] [1.393] [.031] [.007] [1.060] [.631] [.014]
C
EP
0.980 3.190 2.488 0.040 0.999 0.086 0.190 0.001
[.006] [.955] [.477] [.013] [.008] [1.249] [.749] [.017]
C
BP
0.989 1.638 1.740 0.021 0.845 30.500 19.782 0.286
[.014] [2.002] [1.444] [.027] [.007] [1.103] [.591] [.015]
dG
DP
0.991 1.442 1.704 0.019 1.255 27.709 3.650 0.574

[.007] [1.038] [.596] [.014] [.007] [1.005] [.564] [.014]
dG
EP
1.001 0.095 0.046 0.001 1.006 0.937 0.262 0.012

[.006] [.957] [.494] [.013] [.008] [1.164] [.579] [.016]
dG
BP
1.000 0.068 0.033 0.001 0.843 30.924 22.768 0.289
[.007] [.994] [.543] [.013] [.007] [.999] [.555] [.013]