Investments, tenth edition

  Predictors of Broad Market Returns 

 Several studies have documented the ability of easily observed variables to predict mar-

ket returns. For example, Fama and French  

18

   showed that the return on the aggregate 

stock market tends to be higher when the dividend/price ratio, the dividend yield, is high. 

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bod61671_ch11_349-387.indd   365

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7/17/13   3:41 PM

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P A R T   I I I

  Equilibrium in Capital Markets

Campbell and Shiller  

19

   found that the earnings yield can predict market returns. Keim and 

Stambaugh  

20

   showed that bond market data such as the spread between yields on high- and 

low-grade corporate bonds also help predict broad market returns.

 

 Again, the interpretation of these results is difficult. On the one hand, they may imply that 

abnormal stock returns can be predicted, in violation of the efficient market hypothesis. More 

probably, however, these variables are proxying for variation in the market risk premium. For 

example, given a level of dividends or earnings, stock prices will be lower and dividend and 

earnings yields will be higher when the risk premium (and therefore the expected market return) 

is higher. Thus a high dividend or earnings yield will be associated with higher market returns. 

This does not indicate a violation of market efficiency. The predictability of market returns is 

due to predictability in the risk premium, not in risk-adjusted abnormal returns. 

 Fama and French  

21

   showed that the yield spread between high- and low-grade bonds 

has greater predictive power for returns on low-grade bonds than for returns on high-grade 

bonds, and greater predictive power for stock returns than for bond returns, suggesting that 

the predictability in returns is in fact a risk premium rather than evidence of market inef-

ficiency. Similarly, the fact that the dividend yield on stocks helps to predict bond market 

returns suggests that the yield captures a risk premium common to both markets rather 

than mispricing in the equity market.