Regime Shifts in Price-Dividend Ratios and Expected Stock Returns: A Present-Value Approach

We incorporate regime shifts in the mean of price-dividend ratios into the present value model of van Binsbergen and Koijen (2010) who propose a latent variable approach to modeling expected returns and dividend growth rates. We find that accounting for regime shifts results in much lower persistence of expected returns and higher volatility of expected returns, and thus higher in-sample predictability, when compared to the results from the van Binsbergen and Koijen (2010) model. We also show that the main source of the increase in the mean of price-dividend ratios in the mid-1990s is a decrease in the mean of expected returns.