Optimal asset allocation and nonlinear return predictability from the dividend-price ratio

We study non-linear predictability of stock returns arising from the dividend-price ratio and its implications for asset allocation decisions. Using data from five countries - U.S., U.K., France, Germany and Japan - we find empirical evidence supporting non-linear and time-varying models for the equity risk premium. Building on this, we examine several model specifications that can account for non-linear return predictability, including Markov switching models, regression trees, random forests and neural networks. Although in-sample return regressions and portfolio allocation results support the use of non-linear predictability models, the out-of-sample evidence is notably weaker, highlighting the difficulty in exploiting non-linear predictability in real time.