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Do Decomposed Financial Ratios Predict Stock Returns and Fundamentals Better?


  • We would like to thank Robert Van Ness (the editor) and two anonymous referees for constructive and detailed suggestions. Helpful comments were received from the participants at seminar at Florida International University, 2008 SUERF Colloquium (European Money and Finance Forum), Munich, Germany, 2009 SFA Conference, Captiva FL, and 2010 FMA Conference, New York, NY. All remaining shortcomings are our own responsibility.

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We investigate the prediction of excess returns and fundamentals by financial ratios, which include dividend-price ratios, earnings-price ratios, and book-to-market ratios, by decomposing financial ratios into a cyclical component and a stochastic trend component. We find both components predict excess returns and fundamentals. Cyclical components predict increases in future stock returns, while stochastic trend components predict declines in future stock returns in long horizons. This helps explain previous findings that financial ratios in the absence of decomposition find weak predictive power in short horizons and some predictive power in long horizons. We also find both components predict fundamentals.