Equity Valuation and Portfolio Management

MODELING

All active management strategies—whether they are based on stocks, factors or markets—rely on forecasts, and all active managers employ some forecasting methodology. The quest to predict financial market returns and the debate over the futility of this endeavor will likely endure forever.

Samuelson argues that stock markets are efficient at the micro level, but inefficient at the macro level.³³ Although equity prices are known to exhibit an excessive degree of volatility relative to their fundamentals,³⁴ equity markets do appear very efficient at the micro level in the sense that individual stock dividend yields forecast future dividend growth rates in a manner consistent with the simple efficient markets model. That is, high dividend yields indicate low future dividend growth and low dividend yields signify high future dividend growth. Shiller and Jung find that evidence supportive of Samuelson's apparent paradox;³⁵ their empirical tests reveal that the dividend yield has significant predictive power for forecasting future dividend growth rates for individual firms, although measures of an aggregate dividend yield exhibits no significant relationship with future aggregate dividend growth and the coefficient is often of the wrong sign. They interpret these results as evidence in favor of Samuelson's thesis. Campbell and Shiller demonstrate that aggregate stock market returns are forecastable using various valuation metrics and show that the dividend yield for the aggregate ...