The Gilt-Equity Yield Ratio and the Predictability of UK and US Equity Returns
Paper number: 98/15
Paper date: December 1998
Paper Category: Discussion Paper
Richard D. F. Harris
A number of financial variables have been shown to be effective in explaining the time-series of aggregate returns in both the UK and US equity markets. These include, inter alia, the dividend yield, the spread between the yields on long and short bonds, and lagged equity returns. Recently, however, the gilt-equity yield ratio - the ratio between the long bond yield and the equity dividend yield - has emerged as a variable that has considerable explanatory power for equity returns in the UK. This paper compares the performance of the gilt-equity yield ratio with these other variables in the UK and US equity markets, providing evidence on both ex post explanatory power and ex ante predictive ability. It is shown that in the UK, the dividend yield has high explanatory power in-sample but poor predictive ability out-of-sample, while in contrast, the gilt equity yield ratio performs well in both cases. Although the predictability of US equity returns is much lower than in the UK, a similar result emerges, with gilt-equity yield ratio providing both good in-sample explanatory power and a high degree of out-of-sample predictive ability.
JEL Classification Nos: G10, G14
Keywords: Stock returns; Return predictability; Gilt-equity yield ratio.
Corresponding Author: Richard DF Harris, Department of Economics, University of Exeter, Streatham Court, Rennes Drive, Exeter, EX4 4PU, UK, tel: (44) 1392 263215, fax (44) 1392 263242, email: R.D.F.Harris @exeter.ac.uk