DP14107 Price Dividend Ratio and Long-Run Stock Returns: a Score Driven State Space Model

Author(s): Davide Delle Monache, Ivan Petrella, Fabrizio Venditti
Publication Date: November 2019
Keyword(s): Equity premium, present-value models, score-driven models, State space models, time-varying parameters
JEL(s): C32, C51, C53, E44, G12
Programme Areas: Financial Economics, Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=14107

In this paper we develop a general framework to analyze state space models with time-varying system matrices, where time variation is driven by the score of the conditional likelihood. We derive a new filter that allows for the simultaneous estimation of the state vector and of the time-varying matrices. We use this method to study the time-varying relationship between the price dividend ratio, expected stock returns and expected dividend growth in the US since 1880. We find a significant increase in the long-run equilibrium value of the price dividend ratio over time, associated with a fall in the long-run expected rate of return on stocks. The latter can be attributed mainly to a decrease in the natural rate of interest, as the long-run risk premium has only slightly fallen.