Stock return predictability and cyclical movements in valuation ratios

Deshui Yu, Difang Huang and Li Chen

Journal of Empirical Finance, 2023, vol. 72, issue C, 36-53

Abstract: According to present-value models, financial valuation ratios should predict future stock returns or cash flows; however, when tested empirically, these ratios show little power. This paper develops insights into stock return predictability and reconciles the contradictory findings about the information provided by financial ratios. We decompose a financial ratio into a slow-moving component that reflects the time-varying local mean, and a cyclical component that reflects the transitory deviations of the ratio from its local mean. The cyclical components deliver substantially improved in- and out-of-sample forecast gains of stock returns and cash flows relative to the original financial ratios and the historical average benchmark. Conversely, the slow-moving components fail to predict returns, and therefore they are found to disguise the predictive information contained in the financial ratios for stock returns and cash flows.

Keywords: Stock return predictability; Slow-moving and cyclical movements; Present-value models; Nonparametric decomposition (search for similar items in EconPapers)
JEL-codes: C22 C53 G12 (search for similar items in EconPapers)
Date: 2023
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (7)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:empfin:v:72:y:2023:i:c:p:36-53

DOI: 10.1016/j.jempfin.2023.02.004

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