Do Dividend Yields Predict More Than Their Own Future?

The predictive ability of dividend yields for future stock returns does not necessarily imply that dividend yields predict future stock prices. Since stock returns consist of both a capital gain and a dividend yield component, predictability of stock returns by lagged dividend yields mainly reflects predictability of future dividend yields, which make up a significant compoenent of returns. We propose a novel loglinear approximation of stock returns in a capital gain and a dividend yield component and derive testable restrictions of nonpredictability of capital gains. Using Monte Carlo simulations, we show that not accounting for the dividend yield component of returns leads to overrejections of unpredictability both in one-period and multi-period tests. We then test predictability of capital gains given the restrictions of the present value model for predictability of dividends. We find that dividend yields do not predict future capital gains even at long horizons. There is some weak evidence of predictability of total stock returns at longer horizons, but it mainly reflects predictability of future dividend yields, not capital gains. Our results have wide-ranging implications for the way we think financial markets work, asset pricing and asset allocation.