economics

letters
ELSYIER
Economics Letters 46 (1994) 149-158

Why do dividend yields forecast stock returns?

Allan Timmermann
Department of Economics, Birkbeck College, University of London, 7-15 Gresse Street, London Wl P 1 PA, UK
Received 8 December 1993; accepted 23 February 1994

Abstract

This paper presents a continuous time version of Lucas’ (Econometrica, 1978, 46, 1426-1445) asset pricing model
which is capable of explaining the observed increase in the correlation between stock returns and dividend yields as
a function of the length of the holding period provided that certain weak conditions on agents’ utility are satisfied.

JEL classification: GO

1. Introduction

It is well established in the empirical finance literature that the dividend yields of many
common stock indexes are correlated with future returns on these indexes (Campbell, 1987;
Cutler et al., 1991; Fama and French, 1987, 1989; Shiller, 1984). Fama and French (1987), in
the most thorough study of the relationship between yields and returns, report evidence that
the R* in a regression of returns on the yields of the NYSE equal and value weighted indexes
over the years 1927-86 is an increasing function of the holding period for horizons between 1
month (R*= 0.01) and 4 years (R*= 0.13). In recent studies Goetzmann and Jorion (1993)
and Nelson and Kim (1993) question the strength of the reported empirical evidence and
suggest that a large part of the correlation between lagged yields and stock returns can be
attributed to lagged endogenous variable bias. In the absence of a rigorous theory, these
findings constitute a potentially very damaging critique of the ‘stylized’ relationship between
yields and returns.
Various attempts have been made to explain the relationship between stock returns and
yields. Rozeff (1984) argues that changes in the dividend yield is a proxy for variations in the
risk premium on stocks. This explanation emphasizes that the predictability of stock returns is
compatible with the efficient market hypothesis. Shiller (1984), on the other hand, interpreted
the correlation between the dividend yield and future stock returns as evidence of noise
trading in the stock market; noise traders may cause stock prices to deviate temporarily from
their ‘fundamentals’, but prices will eventually have to return to their ‘fundamentals’ value.

01651765/94/$07.00 0 1994 Elsevier Science B.V. Ail rights reserved

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150 A. Timmermann I Economics Letters 46 (1994) 149-158

According to this theory periods with low yields are periods with overvalued stock prices and,
since stock prices are likely to decrease under these circumstances (or increase at a slower rate
than otherwise), this may explain why a low dividend yield will be associated with lower than
average future rates of return on stocks. None of these models explains the increase in the
correlation between returns and lagged yields as a function of the return horizon reported by
Fama and French (1987).
In this paper we will propose a theoretical explanation for the observed increase in the
correlation between stock returns and past yields as a function of the return horizon. The main
idea is that periods with low dividends are also periods with low income and high marginal
rates of substitution between present and future consumption. To induce the necessary savings
to clear the stock market in periods with low income the expected rate of return must be
higher than in periods when the present income is high. Hence stock prices must be very low
in a low dividend state, causing a high value of the yield and a higher future rate of return
through the high yield and a higher future appreciation of stock prices. To make our point
clear we use a continuous time version of the tree model proposed by Lucas (1978) in which
dividends are the only source of income. However, our conclusion will remain valid in an
economy where dividends are positively correlated with aggregate income. Thus the positive
correlation between the yield and future stock returns is due to a wealth effect from dividends
affecting the marginal rate of substitution between present and future consumption reflected in
the Euler equation of a partial equilibrium model with intertemporally optimizing agents.
The plan of the paper is as follows. Section 2 derives the continuous-time ‘tree’ model, and
in Section 3 the positive correlation between the dividend yield and future stock returns and
its relation to the return horizon is demonstrated.

2. The model

We will analyse a representative agent model where the investor can hold two assets: a risky
market portfolio which pays returns in the form of dividends and capital gains, and a safe
bond which pays a known interest rate, Y. In this model income is generated in the form of
dividends accrued to the holders of shares and interest paid to bondholders. In Lucas’ (1978)
model dividends from trees are the only source of income, but here we shall assume that there
is an alternative storage technology (bonds) which allows transfer of wealth between any
periods at a fixed and certain rate (r).
Suppose dividends follow a geometric Brownian motion
dD
- = cx,dt + u,dz, .
D
We will show that the price of a stock (P) which forms a claim on the dividend stream has a
solution of the form
dP
p = cu,dt + a,dz, ,

where CY,,and crP are to be determined from equilibrium conditions. Normally the process
 A. Timmermann I Economics Letters 46 (1994) 149-158 151

generating prices is given ex ante, while here we take the dividend process and investors’
preferences as given and show how these assumptions, jointly with continuous market
clearing, allow us to determine the process followed by the stock prices. Using Ito’s lemma we
can solve the equation for stock prices:

where P, is the initial stock price. At any point in time the investor can either consume part of
the existing funds (C) or invest the funds in risky shares or in the risk-free bond. Let w be the
proportion of the investor’s wealth (W) invested in the risky asset. Then the stochastic
differential equation that describes how the wealth of an investor evolves is given by
- r)Wdt + (rW - C)dt + wW(u, + a,)dz,
dW = w(ad + CX~ . (4)

Computing the conditional mean and variance of Eq. (4) we obtain

E,(dW) = w((Y,+ 9 - r)Wdt + (rW - C)dt , (5)

Var,(dW) = w2W2(ap + ad)2(dt)2 , (6)

where we conditioned on the sigma-field generated by fl, = {Di, Pi ) i I t}. Following standard
practice we will assume that the representative investor is maximising expected (discounted)
lifetime utility;
Z
e-@U(C, s)& , (7)
?a? I S=l
where p is the discount rate. To make the problem tractable we will further assume that the
investor has a utility function of the constant relative risk aversion type, U(C, s) = (Cy - 1)/y,
(y < l), where y denotes the coefficient of relative risk aversion. Under this assumption the
two first-order conditions for C and w imply (cf. Merton, 1971)
(a~ + ad - r>
(8)
w* = (1- y)(a, + ad)* ’
1
21 -r)
W, (9)
where we impose the condition that consumption is non-negative, i.e. a 2 0. Now inserting the
optimal solutions to the investment and consumption policies, (8) and (9), in Eq. (4) to obtain
dW = [w*(crd + aP - r) + r - a]Wdt + ~*(a, + a,)Wdz, . (10)

Using Ito’s lemma, Eq. (10) can be solved to give an equation for the wealth associated with
the optimal investment and consumption policies:

where W, is the initial level of wealth. Finally, to close the model we will assume that the stock
152 A. Timmermann I Economics Letters 46 (1994) 149-158

market clears continuously. With a fixed number of shares (trees) per trader normalised to
one, the equilibrium condition becomes

w*w,=p,, vt. (12)

Using this equilibrium condition we can derive an equation for the stock price as a function of
the preference parameters and the parameters of the dividend process and the risk-free rate.
We summarise our result in Proposition 1.

Proposition 1. Suppose dividends are generated by the geometric Brownian motion process (1)
and that investors maximise a constant relative risk aversion function U(C, s) = (C’ - 1)/y.
Then if the stock market clears continuously, the stock price will follow the process (for y f 0)

dP
- P = CYpdt+ u,dz, ,

(l-Y)~~~\/(l-Y)%s-2Y(u,-~(5))
ap = ,
Y

where the ‘plus’ root is chosen if y > 0, and the ‘minus’ root is chosen otherwise. In the special
case where investors have logarithmic utility and y = 0 we have

Proof. Using Eqs. (3) and (11) in the equilibrium condition (12) we obtain

exp (w*(ad + a,, - r) + r - a - 3 w*~(u~ + od)2)t + ~*(a, + ad)

(13)
Equating coefficients gives three equations in the unknowns P,, up, and g:

(Q;,+ Qd - r>
(9 po
=w,) (1 - y)(u-- + cTd)2’
(ii) w*(ad + Lyp- r) + r -a - +w*2(op + crd)2= ffp - +ui ,
(iii) w*& + Cd) = up . (14)

Inserting the value for w* and a in Eq. 14, (ii)-(iii), these conditions can be rewritten in the
form of two equations in the two unknowns, a,, and 9:
 A. Timmermann I Economics Letters 46 (1994) 149-158 153

1
(cy, + (Yd- r)* ((y, + Qd - Y)* (Lyp+ (Yd- $
(ii) _~
(l-y)(a,+CTJ l?y [ :-~-2(1-y)(g,+rr,)2 -2(l-y)(V~+a,)*

Inserting Eq. (14’),(iii) in (14’),(“)u results in a second-order equation in ap as a function of

the exogenous parameters of the model:

with solutions

(1 - y)CQ + $1- y)*a; - 2y(u, -& (f-r))

up = (15)
Y

We will assume that (1 - y ) 3~i~ - 2y(a,(l - y)r - y(p - r’)) > 0 to ensure that ap only has
real parts. When y > 0, we choose the plus root since the smallest root will be negative for
plausible combinations of the parameter values (CQ(1 - y )Y < y(p - Y*)), which would be
inconsistent with the interpretation of the root as a standard deviation. Similarly, when y < 0,
the minus root will be the only positive solution for a*. Using this solution P, and cyp follow
immediately from Eq. (14). Cl

On the basis of the equations for dividends and stock prices we can now move on to analyse
the relationship between excess returns on stocks and lagged dividend yields.

3. Explaining the correlation between stock returns and lagged dividend yields

Using Eqs. (1) and (3) and defining the excess return on stocks for a return horizon dt as

t+dr
R t+dr =
we have

(cy, - $ai)dt) + a. ~‘dfdzd]+~(eXp{(ad-~~~)df+~~~ididldJ-l)

- (1 + r)dt . (16)
154 A. Timmermann I Economics Letters 46 (1994) 149-1.58

Computing the conditional moments in (16) gives

= exp(a,,dt) - 1 - rdt + 9
,
(exp(a,dt) - 1) , (17)

= exp(2cY,dt)(exp(uzdt) - 1) + ($$)* exp(2a,dt)(exp(atdt) - 1)

l

+ 29 exp(2(g + ad + a,a,)dt)(exp((a, + a,)‘dt) - 1) . (18)

f

The standard definition of R* in a regression of excess returns on the yield does not make
sense in our framework since the innovations in R,,, do not enter additively in Eq. (16). To
define a measure of ‘goodness of fit’ of a regression of the excess return on the dividend yield
we use the result that

Var(Rt+,,
>= E[Var(R,+,,
I+?)]
+var(E[~,+~,
141)
.
A natural definition of R* in Eq. (16) thus becomes

This can be shown to simplify to the normal definition of R* in the case of the linear regression
model. In the steady state where the initial condition (D,,lP,,) does not matter, we get a
particular simple expression for the value of R*:

Proposition 2. Assume that the dividend and price processes began an infinite number of
periods back in time. Suppose that preferences are such that ~(cY, - LYE+ ~,(a, - ad)) + (a, -
a,)* > 0. Then the squared correlation between excess returns on stocks and the lagged dividend
yield is given by

(exp(aidt) - 1)
fiir R* =
(exp(aidt) - 1) + (1 - exp( -czddt))*

Proof. From Eqs. (1) and (3) we can compute

- ap) - +(u; - a;)}t + (ad - up) , (20)

and hence the unconditional moments of the yield are

 A. Timmermann I Economics Letters 46 (1994) 149-158 155

[ t1 0
E $$ = 4 exp( {ay, - cyp+ a&, - a,)}t) , (21)

Var - 4)t)(exp(~, - a,)‘~) - 1) . (22)

Using Eqs. (18)-(19) and (21)-(22) we have

=(exp(a,dt) - 1)2(%)2 exp(2{a, - CX~

+ a,(a, - a,)}t)(exp((a, - a,)‘t) - 1) , (23)

E[VarjR,,,, I$)] = exp(2abdt)(exp(atdt) - 1)

+ exp(2a,dt)(exp(aidt) - 1) 2 exp((2(a, - cy,) + 2ap(a, - ad) + (a, - ~~)~}t)

n

+ 2%exp(2(u, + a;7 + a,a,)dt)(exp((a, + a,)2dt) - 1) exp({a, - CY~

+ a,(~, - a,)}t) .

(24)

To compute the population value of R2, which is independent of the initial condition (Do/PO),
we evaluate R2 as t goes to infinity, using that 2((w, - CX~)+ 2ap(ap - ad) + (a, - a,)’ > 0:

(exp(oidt) - 1) exp(2a,dt)
;ii~ R2 =
(exp(aidt) - 1) exp(2addt) + (1 - exp(cu,dt))2 ’

Dividing through by exp(2cr,dt) gives the result. 0

In the steady state of the model Proposition 2 implies that the value of R2 only depends on the
parameters of the dividend process {ad, a:}. For a finite time horizon, t, the value of R2 will,
however depend on agents’ preferences via the dependence of up and CX~on y and p.
Using L’Hospital’s rule in Proposition 2 we see that when dt is small, the limiting value of
R2 will converge to one. Although the instantaneous value of R2 equals one, it can be very
different from one for very short time horizons. Another interesting case arises when the
return horizon goes to infinity, dt+w, and exp(a,dt) goes to infinity, such that R2 goes to
one. Thus for very long return horizons the R2 of a regression of excess returns on dividend
yields will go to 1. This is in line with the intuition that, by the law of large numbers, the
average rate of return over long horizons is perfectly forecastable from historical values of
dividend yields.
A .further advantage from working with a continuous-time model is that it allows us to
156 A. Timmermann I Economics Letters 46 (1994) 149-158

analyse the implication of the choice of discretisation on the correlation between yields and
returns:

Corollary. An extreme point of the correlation between the excess return and the lagged yield is
given for a value of the return horizon dt that solves the equation

a: exp(aidt)( 1 - exp(-a,dt)) - 2a,(exp(aidt) - 1) exp(-cr,dt) = 0 .

Proof. This follows immediately from differentiating the expression in Proposition 2 with
respect to dt. Cl

The point at which the equation in the corollary is satisfied will be a minimum provided that

a: exp(aidt)( 1 - exp( -addt)) + 2(exp(a:dt) - l)(~ i exp( -_(y,dt)

-U~CQ exp(aidt) exp(-cr,dt) > 0,

otherwise it will be a maximum. If, as in the case below, the numbers suggest a (global)
minimum for a return horizon around 1 month, then one may prefer not to use monthly data
and rather try to obtain either high frequency data or, more likely, use a longer return
horizon.
To demonstrate the properties of the model, we assigned a value of R2 = 0.01 corresponding
to a return horizon of one month (dt = 30) and a value of R2 = 0.13 for a return horizon of 4
years (dt = 30 - 48), and solved the expression given in Proposition 2 for CY~and ai. The
resulting values were (Ye= 0.0256, ai = 9.67E-5, and, since we used a day as our time unit,
these parameters measure the daily mean and variance of the dividend process. The value of
daily mean returns is much higher than the value we can deduce from data on dividends which
may have to do with our assumption that dividends are the only stochastic sources of income.
The introduction of stochastic labour income is likely to bring down the value of (Ye, but
complicates the model considerably (cf. Merton, 1971).
Choosing the above parameter values, we computed the value of R2 given in Proposition 2
for different return horizons, i.e. values of dt. Fig. 1 shows three graphs plotting R2 as a
function of dt. The first graph, which takes a fraction of a month as the time scale, makes it
clear that although the R2 is close to one for very short time horizons, it quickly declines and
after 3 days it takes on a value below 0.05. Plotting R2 for return horizons up to 8 years, or
100 months, the second window shows the familiar phenomenon that R2 increases almost
linearly as a function of the return horizon. For very long return horizons, as shown in the
third window, the relation between R2 and the return horizon is seen to be concave and
bounded from above by 1.

Acknowledgements

I am grateful to Hashem Pesaran, Steve Satchel1 and Ron Smith for comments on the
paper.
 A. Timmermann I Economics Letters 46 (1994) 149-158 157

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158 A. Timmermann I Economics Letters 46 (1994) 149-158

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