Abstract - Return Predictability in a Monetary Economy

In an economy where agents hold money, the short interest rate determines the trade-off between money holdings and consumption. Building on this idea, we develop a theoretical model that shows the transmission mechanism through which the short rate finds its way to stock return predictability regressions.
Based on our model, we construct an empirical cointegration relation between share prices, dividends, and the short interest rate. This residual, that we denote pdR, strongly predicts returns/excess returns at long horizons, even using Hodrick t-statistics. The result that returns are predictable at long horizons is different from recent findings reported by Ang & Bekaert (2006). We differ from Ang & Bekaert (2006) by explicitly accounting for the non-stationarity of the predictors in a cointegration framework. Our theoretical model also suggests that aggregate output might be better suited as a scaling variable than dividends. As a consequence, we also build a variable pyR that relates share prices, output, and the interest rate in a cointegration framework. We show that the pyR-ratio strongly predicts returns at long horizons. pyR is also found to have some predictive power for dividend growth which the pdR-ratio does not. Neither pyR nor pdR have predictive power for output growth and interest rate changes.

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