Estimating dividend growth implied by derivatives markets, the author uses a corrected dividend-to-price ratio to predict S&P 500 Index returns. Both in-sample and out-of-sample returns are substantially better than those predicted using the standard dividend-to-price ratio.
The author applies a forward-looking measure of dividend growth extracted from S&P 500 Index futures and options to correct the dividend-to-price ratio (D/P) for changes in expected dividend growth. He concludes that dividend growth implied by derivatives markets reliably forecasts future dividend growth.
How Is This Research Useful to Practitioners?
Just as the statistical significance of market return predictability has remained open to debate, the evidence of forecasting ability supplied by price multiples has been mostly uneven or biased. The D/P is a noisy proxy for expected returns when the expected dividend growth rate is time varying. The author uses a proxy for dividend growth derived from S&P 500 futures and options to calculate the D/P. The corrected D/P predicts S&P 500 returns better than the standard D/P.
Using a simple log linear present value model, the author shows that the predictable component of returns can be captured through a univariate return regression on the corrected D/P. The corrected D/P is the standard D/P adjusted for variations in expected dividend growth rates.
The author shows that time-varying expected dividend growth rates are important for dividend and price movements because they are highly correlated with expected returns. Standard D/P corrected for variations in expected dividend growth rates is more volatile and less persistent, thus making it a better predictor of returns.
How Did the Author Conduct This Research?
The author uses daily S&P 500 price index data and the total return index data from DataStream, daily S&P 500 futures data from the Chicago Mercantile Exchange, and the end-of-day S&P 500 options data from Market Data Express. The data range is from January 1994 to June 2011.
The log linear present value model the author uses combines the Campbell and Shiller (Review of Financial Studies 1988) present value identity with time-series processes for expected returns and expected dividend growth rates. The analysis is conducted using options and futures with six months to expiration.
The author shows that dividend growth rates implied by derivatives markets reliably forecast future dividend growth rates and that the D/P corrected for variation in implied dividend growth rates predicts S&P 500 returns substantially better than the standard D/P.
The author derives a corrected D/P using the dividend growth rate implied by derivatives markets to predict S&P 500 returns more reliably. Because the prediction power of market returns has great significance in asset pricing, this topic needs further exploration from both academics and practitioners.