Revisiting dividend yield dynamics and returns predictability: Evidence from a time-varying ESTR model

Since the bubble of the late 1990s the dividend yield appears non-stationary indicating the breakdown of the equilibrium relationship between prices and dividends. Two lines of research have developed in order to explain this apparent breakdown. First, that the dividend yield is better characterised as a non-linear process and second, that it is subject to mean level shifts. This paper jointly models both of these characteristics by allowing non-linear reversion to a changing mean level. Results support stationarity of this model for eight international dividend yield series. This model is than applied to the forecast of monthly stock returns. Evidence supports our time-varying non-linear model over linear alternatives, particularly so on the basis of an out-of-sample R-squared measure and a trading rule exercise. More detailed examination of the trading rule measure suggests that investors could obtain positive returns, as the model forecasts do not imply excessive trading such that costs would not outweigh returns. Finally, the superior performance of the non-linear model largely arises from its ability to forecast negative returns, whereas linear models are unable to do.