The modified dividend–price ratio

Vassilis Polimenis and Ioannis M. Neokosmidis

International Review of Financial Analysis, 2016, vol. 45, issue C, 31-38

Abstract: We show that log-dividends (d) and log-prices (p) are cointegrated, but, instead of de facto assuming the stationarity of the classical log dividend–price ratio, we allow the data to reveal the cointegration vector between d and p. We define the modified dividend–price ratio (mdp), as the long run trend deviation between d and p. Using S&P 500 data for the period 1926 to 2012, we show that mdp provides substantially improved forecasting results over the classical dp ratio. Out of sample, while the dp ratio cannot outperform the “simplistic forecast” benchmark for any useful horizon, an investor who employs the mdp ratio will do significantly better in forecasting 3-, 5- and 7-year returns with an ROS2 of 7%, 26% and 31% respectively. In some sense mdp can be considered as a de-noising of the classical ratio as it addresses the major weakness in dp, its presumed inability in revealing business cycle variation in expected returns. Unlike dp, mdp exhibits positive correlation with the risk free return component, and can discern if a low dividend state coincides with a low yield state.

Keywords: Dividend–price ratio; Non-stationary ratios; Cointegrated dividend–prices; Modified dividend–price ratio; Out of sample forecasts; Return predictability (search for similar items in EconPapers)
JEL-codes: G11 G12 G13 G14 G17 (search for similar items in EconPapers)
Date: 2016
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (5)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:finana:v:45:y:2016:i:c:p:31-38

DOI: 10.1016/j.irfa.2016.01.019

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