Market Expectations in the CrossSection of Present Values.pdf

THE JOURNAL OF FINANCE • VOL. LXVIII, NO. 5 • OCTOBER 2013 Market Expectations in the Cross-Section of Present Values BRYAN KELLY and SETH PRUITT∗ ABSTRACT Returns and cash flow growth for the aggregate U.S. stock market are highly and robustly predictable. Using a single factor extracted from the cross-section of book-to- market ratios, we find an out-of-sample return forecasting R2 of 13% at the annual frequency (0.9% monthly). We document similar out-of-sample predictability for re- turns on value, size, momentum, and industry portfolios. We present a model linking aggregate market expectations to disaggregated valuation ratios in a latent factor system. Spreads in value portfolios’ exposures to economic shocks are key to iden- tifying predictability and are consistent with duration-based theories of the value premium. THE MOST COMMON APPROACH to measuring aggregate return and cash flow ex- pectations is predictive regression. As suggested by the present value relation- ship between prices, discount rates, and future cash flows, research shows that the aggregate price-dividend ratio is among the most informative predictive variables. Typical in-sample estimates find that about 10% of annual return variation can be accounted for by forecasts based on the aggregate book-to- market ratio, but find little or no out-of-sample predictive power.1 In this paper we show that reliance on aggregate quantities drastically understates the de- gree of value ratios’ predictive content for both returns and cash flow growth, and hence understates the volatility of investor expectations. Our estimates suggest that as much as 13% of the out-of-sample variation in annual market returns (as much as 12% for divide