A Variance Decomposition for Stock Returns [report]

John Campbell
1990 unpublished
This paper shows that unexpected stock returns must be associated with changes in expected future dividends or expected future returns A vector autoregressive method is used to break unexpected stock returns into these two components. In U.S. monthly data in 1927-88, one-third of the variance of unexpected returns is attributed to the variance of changing expected dividends, one-third to the variance of changing expected returns, and one-third to the covariance of the two components. Changing
more » ... ponents. Changing expected returns have a large effect on stock prices because they are persistent: a 1% innovation in the expected return is associated with a 4 or 5% capital loss. Changes in expected returns are negatively correlated with changes in expected dividends, increasing the stock market reaction to dividend news. In the period 1952-88, changing expected. returns account for a larger fraction of stock return variation than they do in the period 1927-51.
doi:10.3386/w3246 fatcat:fg75e6bi3vbpjjwk5b32icsveq