STOCK MARKET SIGNALS OF CHANGES IN EXPECTED INFLATION

This paper examines the relationship between stock returns and several measures of expected inflation. The proxies include the inflation forecasts extracted from U.S. Treasury bill yields, the mean forecast of surveys conducted by the Institute for Social Research, and the predictions from a rolling time-series model. Unlike recent studies, there does not appear to be a significant negative relationship between stock returns and expected inflation at the beginning of the period. The results are consistent with the hypothesis that stock returns signal changes in expected inflation.     

Stock Returns,Inflation, and Economic Activity: The Survey Evidence

The primary purpose of this paper is the use of survey expectations data to study the empirical relationships between stock returns, inflation, and economic activity. In the course of this analysis and as a secondary purpose, the paper discusses general considerations involving the use of expectations proxies and makes recommendations for econometric techniques. The main empirical findings are: (1) Hypothesized relationships between expected economic activity and expected inflation do not in practice appear to be important in explaining the negative relationship between expected inflation and stock returns. (2) Nevertheless, the survey data do lend some support to the hypothesis of a quantity theory relationship between expected inflation and expected economic activity, holding constant monetary growth. (3) The cross-forecaster dispersion of economic activity forecasts, a proxy for real uncertainty, appears to be a significant determinant of stock returns. Inclusion of this variable eliminates the negative impact of expected inflation.     

Future Realized Return,Firm‐specific Risk and the Implied Expected Return

In this paper, I propose a novel approach to derive a firm‐specific measure of expected return. It builds on recent accounting‐based valuation models developed by Clubb (2013) and Ashton and Wang (2013). The measure is intrinsically linked to commonly used financial ratios, including book‐to‐market, (forward) earnings yield, and dividend‐to‐price, as well as growth and past returns. The empirical evidence shows that it is significantly positively associated with future realized stock returns and also significantly correlated with commonly used risk characteristics in a theoretically predictable manner. The results are likely to be of interest to practitioners and managers in making capital allocation decisions and to academics in need of proxies for firms’ discount rates and expected returns.     

Common stock returns,real activity,money, and inflation: Some international evidence

This paper tests whether the negative relationship between real stock returns and inflation in the United States is in fact proxying for a positive relationship between stock returns and real activity variables in six major industrial countries over 1966–1979. Consistent with Fama's ‘proxy-effect’ hypothesis, we document a negative relationship between inflation and real activity and a positive one between real stock returns and real activity variables. Real activity variables dominate money growth rates and expected and unexpected inflation in explaining real stock returns. A puzzling result that still remains is the positive role of money and the negative role of expected inflation in explaining these real stock returns in all major industrial countries.     

Do Tax Law Changes Influence Ex-Dividend Stock Price Behavior? Evidence from 1926 to 2005

We test the Elton and Gruber model of ex-dividend stock pricing over a period spanning all US tax law changes since 1926. Our results indicate that price drop ratios (ΔP/D) and ex-day returns are related to dividend and capital gains tax rates in the theorized manner. Consistent with tax clienteles, we also find that ex-day price movements of higher dividend yield stocks are driven more by corporate tax rates, while lower yield stocks are more influenced by personal rates. Finally, we demonstrate that the positive relationship between ΔP/D and the dividend yield becomes stronger as the tax differential | t_d− t_cg | widens.     

Regime Shifts in Price‐Dividend Ratios and Expected Stock Returns: A Present‐Value Approach

We incorporate regime shifts in the mean of price‐dividend ratios into the present value model of van Binsbergen and Koijen (2010) who propose a latent variable approach to modeling expected returns and dividend growth rates. We find that accounting for regime shifts results in much lower persistence of expected returns and higher volatility of expected returns, and thus higher in‐sample predictability, when compared to the results from the van Binsbergen and Koijen (2010) model. We also show that the main source of the increase in the mean of price‐dividend ratios in the mid‐1990s is a decrease in the mean of expected returns.     

The dividend–price ratio does predict dividend growth: International evidence

Unpredictable dividend growth by the dividend–price ratio is considered a ‘stylized fact’ in post war US data. Using long-term annual data from the US and three European countries, we revisit this stylized fact, and we also report results on return predictability. We make two main contributions. First, we document that for the US, results for long-horizon predictability are crucially dependent on whether returns and dividend growth are measured in nominal or real terms, and this difference is due to long-term inflation being strongly negatively predictable by the dividend–price ratio. The impact of inflation is to reinforce real return predictability and to reduce – or change direction of – real dividend growth predictability. This provides an explanation for the strong predictability of long-horizon real returns in the ‘right’ direction, and the strong predictability of long-horizon real dividend growth in the ‘wrong’ direction, that we see in US post war data. Second, we find that predictability patterns in three European stock markets are in many ways different from what characterize the US stock market. In particular, in Sweden and Denmark dividend growth is strongly predictable by the dividend–price ratio in the ‘right’ direction while returns are not predictable. The results for the UK are mixed. Our results are robust to a number of changes in the modeling framework. We discuss the results for dividend growth predictability in terms of the ‘dividend smoothing hypothesis’.     

Moral Hazard,Dividends, and Risk in Banks

In non‐financial firms, higher risk taking results in lower dividend payout ratios. In banking, public guarantees may result in a positive relationship between dividend payout ratios and risk taking. I investigate the interplay between dividend payout ratios and bank risk‐taking allowing for the effect of charter values and capital adequacy regulation. I find a positive relationship between bank risk‐taking and dividend payout ratios. Proximity to the required capital ratio and a high charter value reduce the impact of bank risk‐taking on the dividend payout ratio. My results are robust to different proxies for the dividend payout ratio and bank risk‐taking.     

Explaining Returns with Cash-Flow Proxies

Stock returns are correlated with contemporaneous earnings growth,dividend growth, future real activity, and other cash-flow proxies.The correlation between cash-flow proxies and stock returnsmay arise from association of cash-flow proxies with one-periodexpected returns, cash-flow news, and/or expected-return news.We use Campbell’s (1991) return decomposition to measurethe relative importance of these three effects in regressionsof returns on cash-flow proxies. In some of the popular specifications,variables that are motivated as proxies for cash-flow news alsotrack a nontrivial proportion of one-period expected returnsand expected-return news. As a result, the R² from a regressionof returns on cash-flow proxies may overstate or understatethe importance of cash-flow news as a source of return variance.     

Personal taxes and the time variation of stock returns – evidence from the UK

A potential explanation for the time-series predictability of market returns with dividend yields is the differential tax treatment of capital gains and dividends. This article investigates to what extent the predictability of long-horizon returns can be explained by this tax effect. Assuming that after-tax expected returns are constant, we test the derived relationships between pretax returns and lagged dividend yields with UK data. We also compare the predictability of before-tax long-horizon returns with that of after-tax returns. The results indicate that the tax treatment of dividends does not significantly contribute towards the predictability of stock returns.     

Momentum Profitability and Market Trend: Evidence from REITs

This study investigates Real Estate Investment Trusts’ momentum returns in different market states, and explains the momentum phenomenon with a risk-based dividend growth theory of Johnson (Journal of Finance 57:585–608, 2002). Our results show that momentum returns of REITs are higher during up markets. This study finds that winners’ dividend/price ratios are higher than those of losers, and momentum returns are positively correlated with the difference between winners’ and losers’ dividend/price ratios. We also find that momentum returns are higher after the legislation change of REITs in 1992, and that dividend/price ratios of REITs are also higher after 1992, suggesting that a persistent shock to REIT’s dividend/price ratios in 1992 partly explains REITs’ higher momentum returns after 1992. In sum, results of this study suggest that momentum returns of REITs can be jointly explained by a time-varying factor (market state) and a cross-sectional variance in dividend yields.

Taxes,dividend yields and returns in the UK equity market

The higher rate of taxation on dividend income relative to capital gains has been offered as an explanation for the positive relation between stock returns and dividend yields among US firms. In the UK the relative tax rates are the reverse of those in the US. Thus, UK data provides an independent test of the tax-based approach to explaining the relation between stock returns and dividend yields. We find that high yielding stocks earn positive risk adjusted returns, whereas low yielding stocks earn negative risk adjusted returns. We also detect evidence of non-linearity in the performance of zero-dividend stocks. Controlling for firm size, seasonality and market risk we find a significant positive relation between dividend yields and returns. We conclude that the evidence is inconsistent with a tax-based explanation.     

Presidential Address: Discount Rates

Discount‐rate variation is the central organizing question of current asset‐pricing research. I survey facts, theories, and applications. Previously, we thought returns were unpredictable, with variation in price‐dividend ratios due to variation in expected cashflows. Now it seems all price‐dividend variation corresponds to discount‐rate variation. We also thought that the cross‐section of expected returns came from the CAPM. Now we have a zoo of new factors. I categorize discount‐rate theories based on central ingredients and data sources. Incorporating discount‐rate variation affects finance applications, including portfolio theory, accounting, cost of capital, capital structure, compensation, and macroeconomics.     

Predictive Regressions: A Present‐Value Approach

We propose a latent variables approach within a present‐value model to estimate the expected returns and expected dividend growth rates of the aggregate stock market. This approach aggregates information contained in the history of price‐dividend ratios and dividend growth rates to predict future returns and dividend growth rates. We find that returns and dividend growth rates are predictable with $R^2$ values ranging from 8.2% to 8.9% for returns and 13.9% to 31.6% for dividend growth rates. Both expected returns and expected dividend growth rates have a persistent component, but expected returns are more persistent than expected dividend growth rates.     

Real Stock Returns and Inflation

This paper develops the relation between the real rate of return on the stock market and changes in the price level using a multiperiod economy with production. The observed relation between real ex post stock returns and inflation is shown to be consistent with equilibrium in an economy with rational investors. The relation between expected real returns and expected inflation is shown to depend on the form of the economy's production function and on the form of investor preferences. When the production function exhibits stochastic constant returns to scale, the model explains the negative relation between expected real returns and expected inflation which has frequently been observed in empirical studies.     

Inflation,real returns and capital investment

We find evidence for the hypothesis of Mundell (1963) and Tobin (1965) that the expected real return component of interest rates is negatively related to the expected inflation component. In the Mundell-Tobin model, the variation in expected real returns is caused by the variation in expected inflation. Our evidence suggests, however, that the variation in expected real returns is more fundamentally an outcome of the capital expenditures process. Equilibrium expected real returns vary directly with capital expenditures in order to induce equilibrium allocations of resources between consumption and investment. This positive relation between expected real returns and real activity, which comes out of the real sector, combines with a negative relation between expected inflation and real activity, which is traced to the monetary sector, thus inducing the negative relation between expected inflation and expected real returns predicted by Mundell and Tobin but explained in terms of a model much different from theirs.     

Empirical Tests of the Proxy Hypothesis

The proxy hypothesis states that the negative relationship between inflation and stock returns is spurious and really only proxies for the positive relationship between stock returns and real variables. Previous testes of the proxy hypothesis have used actual values instead of forecasted values for the real activity variable. Using only forecasted variables, our results do not support the proxy hypothesis.     

New Evidence That Taxes Affect the Valuation of Dividends

This paper uses British data to examine the effects of dividend taxes on investors' relative valuation of dividends and capital gains. British data offer great potential to illuminate the dividends and taxes question, since there have been two radical changes and several minor reforms in British dividend tax policy during the last 30 years. Studying the relationship between dividends and stock price movements during different tax regimes offers an ideal controlled experiment for assessing the effects of taxes on investors' valuation of dividends. Using daily data on a small sample of firms, and monthly data on a much broader sample, we find clear evidence that taxes affect the equilibrium relationship between dividend yields and market returns. These findings suggest that taxes are important determinants of security market equilibrium and deepen the puzzle of why firms pay dividends.     

EVIDENCE OF A RELATION BETWEEN STOCK PRICE REACTIONS AROUND CASH DIVIDEND CHANGES AND YIELDS

Here, the relation between stock price reactions to announced dividend changes and the yields of the underlying securities is examined. A significant positive (negative) relationship is detected between announcement date returns and yield for dividend increases (decreases) even after controlling for the magnitude of the dividend change. Price reactions associated with dividend increases vary directly with the change in yield and, on average, low-yielding companies do not experience abnormal returns when they increase their dividends. Implied in these results is that the information conveyed through dividend changes varies with the yield of the underlying security and the market response is a function of factors beyond the pure information effect.     

The Fiscal and Monetary Linkage between Stock Returns and Inflation

Contrary to economic theory and common sense, stock returns are negatively related to both expected and unexpected inflation. We argue that this puzzling empirical phenomenon does not indicate causality. Instead, stock returns are negatively related to contemporaneous changes in expected inflation because they signal a chain of events which results in a higher rate of monetary expansion. Exogenous shocks in real output, signalled by the stock market, induce changes in tax revenue, in the deficit, in Treasury borrowing and in Federal Reserve “monetization” of the increased debt. Rational bond and stock market investors realize this will happen. They adjust prices (and interest rates) accordingly and without delay. Although expected inflation seems to have a negative effect on subsequent stock returns, this could be an empirical illusion, since a spurious causality is induced by a combination of: (a) a reversed adaptive inflation expectations model and (b) a reversed money growth/stock returns model. If the real interest rate is not a constant, using nominal interest proxies for expected inflation is dangerous, since small changes in real rates can cause large and opposite percentage changes in stock prices.