Predictability of Equity Returns over Di¤erent Time Horizons: A Nonparametric Approach (Preliminary Version)

This paper aims to test an important hypothesis in \u85nancial economics: whether equity returns are predictable over various horizons? The conventional wisdom in the literature is that aggregate dividend yields strongly predict excess returns, and the predictability is stronger at longer horizons (Fama and French (1988), Campbell (1991), and Cochrane (1992)). In contrast, Ang and Bekaert (2007) \u85 nd that dividend yields, together with the short rate, predict excess returns only at short horizons, and do not have any long-horizon predictive power. In this paper, we undertake an analysis of both in-sample and out-of-sample tests of equity return predictability to better understand the empirical evidence on return predictability over di¤erent time horizons. We \u85rst propose a nonparametric test to examine the predictability of equity returns, which can be interpreted as a signal-to-noise ratio test. Our empirical results show that the short rate, dividend yields and earnings yields have good predictability power for both short and long horizons, which is di¤erent from both the conventional wisdom and Ang and Bekaert (2007). Also, using our nonparametric test, a comprehensive in-sample and out-of-sample analysis documents that the predictor variables (dividend yields, earnings yields, dividend payout ratio, short rate, ination, book-to-market ratio, investment to capital ratio, corporate issuing activity, and consumption, wealth, and income ratio) have predictability power on equity returns but this cannot be well captured by linear prediction models. In addition, we use the nonparametri