EtsEVtER Journal of Financial Economics 41(1997) 16% 203

Book-to-market, dividend yield, and expected

market returns: A time-series analysis
S.P. Kothari, Jay Shanken*

WC find reliable evidence I~JI both book-to-market (9 Nt and dividend yield track
time-series variation in expect& real stock returns over the priod IX!6 91 (in which
B M is stronger) and the subperti 1941-91 (In which dividend yieid is stronger).
A Bay&an bootsmap procedure implies hat an investor with prior belief 0.5 that
expected re:ums on the equal-weigh’ed index are never negative comes away from the
full-period B. hi evidencxz with posterior pro&hi@ O.oII for the hypothesistO.I4 with the
impact of the I933 outher temperedI. Altnough this raises doubts about market c%cicnq.
the post-t940 evidence is consr$tent with expected returns always heins positive.

There is considerable evidentle that stock returns are predictable. The aca-
demic, literature on return predictability goes back at Ieast to the late 1970s.

*Corresponding author.
We thank Ray Bail. Peter Bossaerts. Stwe Caulej-. Gene Fama. K~I French (the r&met. Burton
HoMieN John Long &iii Schwert (the editorl Rob Stambaugh. Jerr: Warner. Robert Whitelaw.
and espectill~ Johnathan Lewellen. Aiso. thanks to participants in semtnars al NBER. the Southern
Finance Association. Virginia T&, London Business School. Dartmouth. Washington University.
Yale. the University of California at Irvine and Los Angelex Camhn~. and Clniversily of
Rochester. We gratefully acknmvledgfinancial wpport from the John M. Ol*n Foundation and the
Bradley Policy Research Center at the Simon School. University of Rochester. Assistant: from K Em
Goetz and Jane Muellner on manuscript preparation is appreciated.

0304-80SXA7,Sl7.CIO 4‘ 1997 Elsevier Science S.A. All rights reserted

PIf s0304-405x(97)00002-0
170 S. P. Kothari, J. Shanken /Journal of Financial Economics 44 (I 997) 169-203

Several studies (e.g., Fama and Schwert, 1977; Keim and Stambaugh, 19886;
and Fama and French, 1988) regress returns on predetermined variabks, includ-
ing past returns, to infer the existence of statistically significant time-variation
in expected returns. Among the predetermined variables, many studies have
found dividend yield to have predictive power in both cross-section (L&en-
berger and Ramaswamy, 1979) and time series (Rozeg, 19@ Shifter, 19w,
Fama and French, 1988a, 1989; and Campbell and Shilfer, 1988). Since the
publication of Fama and French (1992, 1993), the book-to-market ratio
(B/M) has emerged as a strong contender as a determinant of expected returns.
Fama and French, Davis (MM), and Chan et al. (1995). among others+
provide evidence that B/M significantly explains cross-sectional variation in
average returns, although Kothari et al. (1995) show that the effect is weaker
in large firms (also see fought-an, 1996) and argue that the magnitude and
signiGcance of the effect may be overstated due to data mining and a variety
of selection biases in the COMPUSTAT data base (also see Breen and
Korz,, czyk. 1994
The literature emphasizes two views of the predictive power of financial ratios
that are relevant in both time series and cross-section. The first (e@cient
markets) view has been referred to by Fama and French (1988b) as the
‘discount-rate effect (also see Keim and Stambaugh, 1986). Holding expected
cash flows roughly constant, anything that incmases the rate at which cash Sows
are discounted (e.g., changes in risk or liquidity) lowers market value and
irtcmss both eqxcted return and financial ratios. This assumes+ ofcoum that
the most rarmt value in the numerator (dividend or book value of equity) does
an adequate job of controlling for expected future cash f?ow. An alternative
(ineffi&nt markets) view is that financial ratios refkct the extent to which the
market is overvalued (low ratios) or undervalued (high ratios) at a given point in
time. fn the &se of underpricing. for example, future returns (and thus ?rue’
expected mums) will be high insofar as the undervaluation is likely to be
corrected over the given horizon.*
In this research we evaluate the ability of an aggregate B/M ratio to track
time-series variation in expected market index retunrs, and compare its forecast-
ing ability to that of divrdend yield. We employ a vector-autoregressive (VAR)
framework to evaluate the statistical signiRcance of the regression evidem~ of
predictability of expected returns. The bootstrap simulation procedure is used to
test the null hypothesis of no predictability as well as to assess the magnitude
and economic significance of the relation between expected returns and its
detetminants, such as B/M and dividend yield. Finally. we extend the traditional
bootstrap procedure by developing a Rayesian-bootstrap simulation. With the

‘A third motivation for the cro6s-JeFtjo nal investigation of dbidcnd yield is taxes. This study.
howvcr. does not focus on the tax motivation.
 S.P. Ko~hwi, J. Sbanken/Joumai ojFinanciai Economics 44 (1997) 169--X83’ 171

exceptions of MacBcth and Emanuel (1993) and independent work by Pontiff

and SchalI(1995), B/M has not been considered in time series and the relative
abilities of B/M and dividend yield have not been evaluated.”
Our time-s&es investigation at the market level employs the Center for
Research in Security Prices (CRSP) equal-weighted and value-weighted port-
folio annual returns data. Real returns ate computed using the observed CPI
inflation rate. Corresponding yields 4qual to dividends paid in the preceding
year divided by the price level at the end of that year are also computed from
CRSP data as in Mama and French (198&I). Time-series data on B/M are for the
stocks included in calculating the Dow Jones IndustriaJ Average. Return and
B/M data are availabic since 1926, permitting us to study B/M over a longer
period than has been possible in the cross+eot ional literature. Use of the Dow
B/M variable along with broader index returns is in the spirit of Fama and
French (1989), who regress bond returns as well as stock index returns on both
stock yields and bond-yW spreads, viewing the explanatory variables as
proxies for the overall state of the aggregate economy.
Although the use of ordinary least squares (OLS) regressions to assess the
ability d dividend yield rnd B/M to forecast one-year returns might appear to
be straightforward time-series regressions of returns on beginning-of-period
yield measures are subject to sma&sampk biases (Starnbaugh, 1986; Mankiw
and Shapiro. 19%). The bias arises from the fact that the mgre&on disturbances
are correlated with future vahrcs of the i&epe&ent variable. A large imzasc in
price tends to product both iitrge positive returns and a ooatemporaneous
d4mease in yield. Since the yield only gradually reverts to a normal tevsel,large
returns tend to follow what. in same appear to be relatively high yields. This
imparts an upward bias to the regression slope co&Gent. The bias is opposite
to that which arises when the laggcd dependent variable is inch&d as a re-
gressor, since the beginning-of-period yickl is highly negatively cornfated with
the lagged return, In large samples, the sample mean of the yield measure
converges to the true mean (under ftiriy general a-ssumptions), eliminating the
source of the spurious correlation between yield and return.

-____ -_--~
zMac&eth and Emanuel(1993)prcscntsevidcmz that price-t&rook hassomsfomcastingabilityfor
anodii @-year mums on the standard and poor’s IRdwrial index from I!246 to 1982 tt is not
dear (to us) from the discussion in tFie paper. however, wh&cr TiK p&2 and book valuer simulated
under the null hypothesii were t&ted in a manner similar tv tha4obsmvd in the haiotil data. If
ov(, there is some question as to the reliability of the rest&a We hare similar conarns about the
hvvtstmp pra.tculu~r vf Gvetzmann and Jorion (1993), in which them ix no relation betwcm
raodvti Etums and tbe (actual) dividends used in computing divihttd yield. It is natural, uttdcr
the null hyphcsb, to have returns iodepcnknt d past divider&, but returns sbotdd anticpate
futorr: dividends in an e&ient market. even if expected returns are constant (e.& see the evidence
in Kothari and !Shankeu, 1992L The VAR framework discussed below allurn this titure ofthe data
to be relleucd in the simulated modd.
172 S.P. Korhari. J. Shanken/Joumal of Financial Economics 44 (1997) 169-203

Since large-sample inference is suspect in this context, we resort to simulation

methods to evaluate the statistical significance of the regression evidence on
return predictability, as in recent studies by Hodrick (1992), Goetzmann and
Jorion (1993), and Nelson and Kim (1993). In particular, we employ a VAR
framework to simulate an empirical distribution for the OLS slope coefficient.
As previous authors have noted, the VAR simulation approachis appealing
in that it explicitly models the process relating regressiondisturbancesto
future values of the independent variable. Moreover, the complications intro-
duced by using overlappingmultiyear returns(the usual standarderrors are
too low) can be addressed, along with conditional heteroskedastitiiy of the
disturbances. The existing simulation evidence indicates that conventional
asymptotic methods are not reliable,evenin the nonoverlappingreturn appiiea-
tions consideredhere.
Thus far, the simulation literature has focused on testing the point null
hypothesis of no pfCdiCtdbi!ity in expected returns,i.e.,a slopecoe&ieut of zero
in the rrtum t-egres+,n While this is ,L natural place to start, ;&wouid be useful
to be abie to say somethingmore about the magnitudeand economicsign&
canceof thetrue cmeBicht if thenull hypothesisis rejezted.Weexploretheissue
of economicsignibcanceby evaluatingthe powerfunction of the test in simula-
tions.This permitsa formal testof the compositenull hypothesisthat the slope
co&e&t is less than some prespeeifiedvalue. Fama and French (1988a)
provide some indication of economic sig&cance and the impaet of bias by
looking at the out-of-sampleforecastingperformanceof their estimated re-
turn/yield relation Degreesof freedomarea scarceresourcewhen usingmubi-
periodreturns.however,limiting the usefulness of this approach.Hodriek (1992)
also simulatesa particular a&native to explorethe power of his tests
In addition+ we deveLopa Bayesian-bootstrapsimulation procedurethat
estimatesthe likeli~ of d&rent slopevalues,conditional on the historical
OLS estimate. The information contained in the likelihood function nieeiy
comptementsthat conveyedby conventional pvalue analysisand provides
a richer framework in which to assesseconomic significance.Moreover, tire
Etayesian interpretationof thelikelihood functionallows usto easilyincorporate
prior belie&about phursibleexpectedreturnvariation and to explorethe impact
of differentviewsof market et%iencyon the conclusionsdrawn from the given
sampleevidence.
Overall, we find evidenceof economicallyand statistically significantvari-
ation in one-yearreturnsforecastby the B/M ratio overthe 192691period.Tbe
slopecodficients, especiallyfor the equal-weightedindex, are so large as to
suggestthat expeetedreal returnsaresometimesnegative,raisingdoubtsabout
marketelBciency.The evidencefor dividend yield is comparable‘for the value-
weightedindex returnsand weakerfor theequal-weightedindex.In the 1941-91
subperiod,both B/M anddividendyield track expectedreturn variationand the
evidenceis eon&tent with positive expected returns. The B/M and dividend
 S. P. Kothari. J. Shanken 2Jownal of Financial Economics 44 /1997) 169 203 173

yield results are comparable for the equal-weighted index, but the dividend yield
evidence is stronger for the value-weighted index in the subperiod.
We report descriptive statistics in Section 2 and initial regression results in
8ection 3. Section 4 describes our bootstrap simulation methodology, while
Section 5 describes the computation of bootstrap p-values and likelihoods based
on the simulations. Section 6 d&cusses the robe of prior information about
expected returns in the context of testing the sensitivity of expected returns to
determinants like B/M and dividend yield. Bootstrap simulation results are
presented in Sections 7 and 8. Section 7 focuses on the magnitude of the slope
coe@cients on the finaucial ratios in the expected return refation, while Section
8 provides tests of I?K hypothesis that expected returns are always nonnegative.
section 9 summarizes our main findings

This section begins with a brief description of the data ~sI, fohowed by
‘descriptive statistics for the time series of B/M. dividend yield, and market index
returns To ensure that the B/M ratio is known to investors at the beginning of
the return year, we measure annual returns from April of year t to March of year
r~1aad~thesefetumsontheratioofbookvaluefor~eart-ltopricc
at the end of Match of year t. The corresponding dividend yiefd equals dividends
paid from April of year t - 1 tohlarchofyearrdividedbypriceattheendof
March of year r. These tlttios and returns an t&erred to as the ‘year r’
observations
The hook value ‘per share’ that corresponds to the Dow Jones industrial
Average is published in The Valve Line fnmamenf +xy. Time series data are
available since 1920. Book value data for 1920-35 are based on estimates by
The V&e Line. The book value for year t - 1 is deflated by the Dow Jones
industrial Average at the end of March of year t + 1 to obt&n the B/M ratio,
which is used to forecast returns for year t.
We begin by presenting some descriptive statistics in Table I for returns, B,IM,
and dividend yield over the sample Period 1926-9! and subperiod 3941-91.
Retcm and dividend yield information is for both equal- and value-weighted
CJSP indexes. All three series are positively skew& with the equal-weighted
returns being the most highly skewed. For the whole period, the average real
return on the equal-weighted (value-weightad) index is 15.3% (9.4%) with
standard deviation 38.8% (23.9%). The minimum is, - 61% ( - 48.4%) in 1937
and the maximum is 214% (85.7%) in 1933. The returns on both indexes are
lower and less vohtile in the frost-1940 subperiod.
The mean of the B/M series for 1926,-91 is 70% with standard deviation 23%.
The minimum is 27% for 1929 and the maximum is 148% for 1933, the same
year in which returns achieve their maximum for both indexes. The mean of the
Wpfive statistics for the return and financial ratio variae
.-._ _“” ...-_ -^ - .-. . ..- - . .._ ---.----..I .-...__.._. ~.~ I _,.._---_ g
Variable Mean Std. Skewness
Mm VI Median 03 Max 2
dvn.
ll~l,_ I-.. --_ . . ._ I ..- ._- ..__ ___--_-“- 8
- -2,
Pld A: Perind I92t%91 s
Equal-weighted return (%) IS.3 38.8 2..30 - 60.9 - 6.3 10.2 27.7 213.9 2
Value-weighted rctum (%) 9.4 23.9 0.36 -
- 48.4 4.3 9.0 21.4 85.7 i
3ook-to-mtuket (o/6) 69.5 22.7 0.87 27.2 52.8 66.5 80.5 147.7
Equal-weighted dividend yield t %t 3.65 1.44 1.09 I.41 2.71 3.22 4.31 8.21 2
2.66 3.33 4.11 5.06 9.27 B
V&c-weighted dividend yicJd t%t 4.40 1.42 1.41
7
:.
Panel B: Patlod IWl-91 9
Equal-weightcd return (%I 12.5 23.2 0.53 - 31.0 - 3.0 9.4 25.0 3
75.”
8
Value-we&)hcd rctum (%) 8.6 17.2 0.01 - 27.1 3.7 8.4 19.7 42.2 3.
Book-to=market (%) 70.7 I9.Q 0.59 42.8 54.7 69.0 81.4 118.6 0
Equal-w&&cd dividend yield (%I 3.67 1.35 0.94 I.85 2.71 3.18 4.51 7.27 h‘
V&c-wcightcd dividend yield W) 4.24 t.23 I.04 2.66 3.21 4.05 5.06 8.39 B
----- ___--. -~____ _--- ___l-----
5.
Equ&wei$htcd return is the CRSP equal-weighted snnual real mum inclusive of dividends from April of year t to March of year I t 1. a
Vaksl-weighted return is the CRSP vaiuc-weighted rnnual real Wurn inclusive of dividends from April of year I to Murch of year I + I. 2
Book-to-market is the ratio of the book value per share at the cud of year I - I of the stocks in the Dow Jones lndustriai Average to the Dow Jones $
industrial Average at the end of March of year I. 2
Equal-weighted dividend yicid is the ratio o~dividendr paid from April of year t - I IO M&r& ofye..~r I IO the accumulated value of one dollar invested in the 2
CRSP cquabwcightcd in&x exclusive of dividends for one year ending on March 3 I of year 1. P
Value-weighted dividend yield is the ratio ofdividends paid from April of year I - t ta March of year r to the accumulated value olonc dollar invested in the s
CRSP value-weighted index cxch~dve of dividends for one year ending on March 31 of yair 1.
 S.P. Kotltari, J. ShankenlJonmal of Financial Economics 44 (1999) I@-201 175

equal-weighted dividend yield series is 3.65% with standard deviation 1.44%.

The minimum is 1.41% for 1934 and the maximum is 8.21% for 1938. Dividend
yields for the value-weighted index are higher with a mean of 4.40%. AU ratios
are Iess volatile over the post-1940 subperiod.
Both financial ratios are highly autocorrelated, with 1926-91 first-order
autocorrel?tions of 0.68 for B/M and 0.56 (0.55) for the equal-weighted (value-
weighted) index dividend yield. We cannot reject the null hypothesis that each
series is generated by a first-order autoregressive process. The correlation
between B/M and equal-weighted (value-weighted) dividend yield is 0.42 (0.66).
Tbe higher comlatioll with the value-weighted yield is reasonable, since the
B/M ratio is for the relatively large firms in the Dow index. The financial ratio
autocorrelations are all higher in the post-1940 perid close to 0.80. Ako, B/M
is lO-15% more highly correlated with each dividend yield series.

3OLSTt?pSfhrrafts

This section summarizes OLS regression results, dckrring an assessment of

small-sample biases to later slctions. Table 2 presents the results of regressing
annual returns on B/M (panel A) or dividend yiekl (panel 8). Tbe table reports
rest&s using both equal- and value-weighted index returns tar the entire sample
period 1926-91. We also explore t+?esensitivity of resuJt.s to tbe 1933 outiier by
running tbe regres&ons with rhL: outlier deleted or ‘trunca&&. In the latter case,
the regressions are run as if the extreme 1933 values for rez~ra (214% equal-
weighted, 86% value-weighted) and B/M (148%) had been the next highest
SampIe values (129% equal-weighted retura, 74% VahJe-weighted return and
119% B/M). Sinoe systematic deletion of the single observation most supportive
of a mtive regression slope is obviously biased against such a finding, trunc-
ation is adopted as a man neutral means ‘of evaluating sensitivity. This
approach is in the spirit of the statistical technique known as Winsorization
(see Dixon and Massey, 1969).
Tbe standard errors and r-statistics (except White t) aie the usual OU
quantities. The B/M and dividend yield variabies are scaied by ttir respective
standard deviitions so that the dopes can be interpreted as the change in
expected return for a one-standard deviation change in, the values of the
financial ratios This he@ in assessing the economic significance of a given beta
and facilitates the formulation of o&s prior beliefs. Thr full-sample (‘All’) slope
estimates in Table 2 are all large in economic terms and most ate more than two
or three standard errors above zero in these simpie regressions.
The 192691 slope coe&ient on B/M using the equaCweighted index is
20.2%. with OLS standard error 4.1% and t-statistic 4.87 (pvalue O.OQO).Tbe
adjusted R2 of nearly 26% is quite large relative to past findings for l-year
returns, and the estimated slope is enormous. If B/M increases from its historical
176 S.P. Korhari, J. ShankeniJournal qfl;inoncial Economccs 44 (1497) 169.-203
 S.P. Korhari. J. ShankenlJoumal of Financial Ectmomics 44 (1997) 169- 203 f77

average of 70% by one standard deviation (23%) the expected real return, which
averages 15.3% is forecast to rise by 20.2 percentage points As we shall see
later, adjustments for small-sample bias do not materially alter these con-
clusions. Deleting the 1933 outlier cuts the B/M coefhcient in half, but the
estimate is still very large and highly statistically significant. Truncation also has
a substantud, but smaller. efkct. Turning to the regression results for the
value-weighted index reveafs that the Dow B/M ratio explains a much smaller
fraction of the time-series variation in these returns than for the CBSP equal-
weighted index.
Dividenf? yieM, in contrast, is somewhat better at explaining variation in
returns on the value-weighted index than on the equal-weighted index. For the
full sample, dividend yield explains less of the variation in value-weighted in&x
returns than does B/M, but explanatory power is similar with deletion or
truncation. Although equal-weighted dividend yield steadily incrzases from
1929 to 1932, it drops nearly by half, to 3.44%. at the beginning of 1933. fience,
deleting the 1933 observation actually strengthens the telation between equal-
weighted returns and dividend yiefd. Although value-weighted dividend yield
also begins to drop, at 694% it is still well above its mean 4.40% at the
beginning of 1933 and hence oeietion weakens the value-weighted rdation.
The slightly better abiJity of dividend yield to explain value-weighted index
rctumslnayberrlatcdtothttactt:latalarl4efractiaaoitbcfirmsintbeindexdo
not pay dividends Thedone, these firms’ dividend yields cannot refkct
in expected market return. Since firms that do not pay dividends are, on average,
smaller in market capilaiization, they have a relatively small efkt on the
dividend yield of the value-weighted index.
Multiple regressions of returns on B/M and dividend yiekl over the 192691
period, shown in Table 3, teU essentiahy the same story as the univariate
regre&ons B/M dominates dividend yield in explaining equal-weighted index
returns B/M also outperforms dividend yield for value-weighted ir&x returns
when the 1933 outlier is inch&d, but otherwise the explanatory power of the
variables is similar.
Given the concerns about small-sample biases mentioned earher, we can
hardly have much confidena in the White (19f8tJt asymptotic adjustment for
heteroskedasticity shown in Table 2. We use it as a heuristic for (we hope)
identifying situations in which results may be particnfarly sensitive to he&m-
skedasticity problems or other misspecifkations. This appears to be the case for
the full-sample equal-weighted index regressions, in which the White r-statistic is
about 45% smaller (larger) than the usual OLS t-statistic for the B/M (dividend
yield) slope. Exploratory regzssions (not reported) of squared or absolute
return residuals on B/M suggest a signifkantly positive conditional variance
relation, whereas the refation for dividend yield is negative and statistically
insignificant. We examine weighted least squares and nonlinear regression
specikations for B/M, w*ith little impact on our basic conclusions. There is no
Table 3
OLS muitipic regression msuits: 1926 91

R I*, = z + j?, R/M, -I- fi*DYki, + u,. ,

I___ -._._.__ __I_----.____-. .---.-.-. -~.-- I-_~ --_,___- -I__- P
IlKkX Sample a (%I s(u) (?b) r-stat h,f%) slh,) 1%) r-stat ‘Vhitc ha (%) s(hl) (%) r-stilt White Adj. R2 $
l-stat r-stat in % 6
___- ..-l”-.-* .-I-x _“_ ----- .- --------.I----..- -. ““- -. -..--..--- -._ .l,.__ll___
Equal weight All - 43.8 14.6 - 3.00 21.1 4.6 4.69 I.32 - 2.3 4.6 - 9.49 - 0.41 25.0 5
E
I933 deleted - 25.6 12.9 .- I,99 9.3 4.1 2.30 115 2.7 4.1 0.68 0.65 10.3 q
1933 truncated - 32.7 13.5 -- 2.41 14.9 4.2 3.32 I! 5% OS 4.2 (D.13 0.12 15.9 $7
Value weight Ail -. 19.4 9.8 - 1.97 fj.9 3.8 IJJI I d 2.5 3.8 9.65 0.59 IO 7 2
1933 deleted ii.4 IQ0 --1.701.14 2.3
45 3.6
3,8 9.76
I.19 O,b?
1.03 3.4
3.7 3.6
3.8 (893
9.93 0.83 3.4 !g
1933 truncated -- 17.0 10.0
0.89 7.7
.- - ,.,._. I ..--_ ..-.. - ._..__ ._ _..__^ .______ 9
.__
i:
R,, f is the CRSP equal-weighted or value-weighted real rcturn inclusive of dividends from April of year t to March of year t + 1.
E.
R/M, is the ratio of the book value per share at the end of year ’ - 1 ot the stocks in the Dow Jones industrial Average to the Dow Jones IndustrLI Average 3
at the end of March of year t. B/M, ir deflated by its standard deviation over the sample period. ::
DY)d, is the rAti of dividends paid from April of year t - 1 to March of year t to the accumulaIed value of one dollar invested in the CRSP equal- or 2
vaiu&weightcd index exclusive of dividends for one y-r Ending on Merch 31 of year I. DYU, is detlatcd by its standard deviation over the sample pried. s

;h:
\4
EL
8
Tabkr 4
OLS regression results: 1941 91
_ _ “. .__..._.-_- _._.,..__..- --- _.-... *
crin ‘$ s(a) in % t-stat h in % n(h) in % I-mtat White Adjusted 3
Index
t-stat R’ in % 6
_.______ -._--. ^ “. ‘. - -~ .-. _.- --------- “r
9. .
Panel A: R,, t =x+/IR:M,+u,~,
Equal weigh: - 19.9 1 I.9 - I.68 g.7 3.1 z.03 2.79 12.3
Value weight - 7.8 9.2 - 0.85 4.4 2.4 1.86 2.01 4.7

PanPI B: R, I , = I c- gDYU, + u, , ,
Equal weight - 2.7 8.R - 1.45 9.3
Value weight - IS.0 R.I -- l.g6 6.9

_________ ^ .“. - -.-s....,.l “. ._ ._

Panel C: R, + I~o a + /iI RIM, + /?~DYid, + U, ( 1

. l_.“_..-..- ..__- --..- h

.dh,f r-atat White hr J(hz) f-stat White Adj. R’

r-mtat r-stat in % 1.
. _.-_._.. _ .” _. ..-- -.-- ~.._- ._.-._ --..- 4
Q
Equal weight - 257 11.9 - 2.13 g.4 3.4 MO 1.68 6.60 3.44 1.92 1.87 16.8 2
Value weight 13.8 9.1 -L I.111 -. 1.0 3.2 -931 -’ 0.31 757 3.24 2.34 2.26 12.7 s
-._I--__“- --. ..- _ _ .^ ._..___- -.--- ..-..-_ -.-- __-- 3
4
R,, , is the CRSY equal-weighted or valw~wcighted real return inclusive of dividends from April of year I to March of year t + 1.
B
R,‘M, is the ratio of the book value per share at the end of year t - I of the stoekr in the Dow Jones fndustrial Average to the Dow Jones Industrial Average
at the end of March of year t. R/M, is Mated by its standard deviation over the sample period. $
DYM, is tbe ratio of dividends paid lrom Aprtl of year t - 1 to Match of year r to the accumulated value ol one dollar invested in the CRSP equal- or
value-weighted index exclusive of dividends for one year ending on March 31 of year r. DYtd, ir deflated by its standard deviation over the sample period.
180 S.P. Koihari. J. Shanken Journal of Financial Economicr 44 (1991) 169 203

significant association between B/M and squared or absolute residuals (t-

statistics less than 0.5) with the 1933 outlier deleted, and both methods of
treating the outlier greatly reduce the huge gap bktween conventional and White
r-statistics.
Table4contains regression results for the 1941--91 subperiod. The motivation
for examining this subperiod is that, as noted by Officer (1973) and !Schwert
(1989). stock return variability was unusually high during the 1929-39 Great
Depression. Dividend yield modestly outperforms B/M over the subperiod with
equal-weighted index returns and substantially outperforms R/M with value
weighted returns. Analysis of post- 1962 data reveals that dividend yield tracks
variation in expected returns through time. while the evidence for B/M is
inconclusive. Our full-period and subperiod results are similar to those reported
by Pontiff and Schall(l995). who also include default and term premiums and
three-month T-bill yield in their regression model and whose subperiod begins
in 1959.
O..eral;. WCfind +r;!i bc+b B/hi and Gvidend yield appear tc track variation
in market index returns, but full- and subperiod analyses suggest that neither
variable consistently dominates the other in its explanatory power. Apart from
the dramatic full-period, equal-weighted index (BjM case), the OLS slope
estimates range from 4.4% to 9.3%. still large in economic terms. These values
of beta imply that a one-standard-deviation change in tbe value of B/N or
dividend yield is associated with a shift of about 49% in the expected real
return on the index.

We now consider simulation methods to examine whether the condusions

above are materially afTected by small-sample biases. Like Nelson lurd Kim
( 1993). we posit a simple VAR model of returns and determinants of expected
returns. In this model. the expected value at time t of the return realized at t + I,
r, + t, is a Iinear function of the variable X, (dividend yield or B/M), which follows
a simple autoregmssive process:

rt +I = x i- fix, + u, + l; u * i.i.d. (0. & (1)

-‘It+1 =I’+~xr+rr+~;r W i.i.d. (0. tr:). (21

where u and c are white noise error terms with contemporaneous covariance a,..
The parameters in Eqs. (1) and (2) are estimated for annual real returns data by
OLS.
Stambaugh (1986) shows that the bias in the OLS estimate b of fl in Eq. (I) is

w - 8) = &+/u,!)E(p - 4, (3)
 SP. Korhari. J. Shankm/Jownal of Financial Economics 44 (IQ971 MY--203

where p is the OLS estimate of 4 in Eq. (2). As expected, the residuals in the
return regression equation are strongly negatively contemporaneously corre-
lated with the residuals in the financial ratio autoregression (2). For the 1926-9 I
period, the correlation is - 0.80 in the case of B/M and - O-65 ( - 0.79) for
equal-weighted (value-weighted) dividend yield. Over tbe post-1940 period,
residuals in the two dividend yield VAR’s an more strongly contemporaneously
correlate4about -O.%Sineach~The~ti~correlationisiMtucedbythe
fact that price increases tend to reduce the financial ratios wbik resulting in
positive returns. Thus, by (3), tbe OLS slope estimates are biased upwards.
Combining (3) with the fact that the bias in p is approximately - (1 + 34)
divided by tbe sampk size T (Kendall 1954) suggests the following bias-
adjusted estimator of 8:
b A = b + &r/&l + 3pA)/7-. (4
where s, and s,” are sample moments of the OLS residuals from Eqs. ( I ) and (2)
and PA = (rp + l)/(r - 3) is a bias-adjusted estimator for 9. After computing
the bias-adjusted estimates hA and PA, the intercepts are specitkd by setting tbe
avm fitted vahres in (1) and (2) equal to the sampk means. Corresponding
adjust& (~rf residual pairs are tben obtained from (It and (2), with each
rtsiciual taxies averaging to zero over time. Tbeae residuals are used in the
bootstrap shdatiom which we describe below.
The system is started up with the historical value for x at tbe heginning of the
sampk lreriod. Given a hypothetical value of /3 and substituting tbe estimator
pAforAtimetieriesofreturnsaadeewvalucsoCxanthengatcratedfnmr(l)
and (2) by randomly selecting adjusted (a. r) residual pairs with mt.
Finally, tbe simulated time series of returns, which has the same length as the
original data used to estimate Eq. (1 L is regressed on tbe simulated time series of
X*S.The estimated slope from this regmssion is saved. This procedure is repeati
2StMltimes with the hypothetical @value fixed and each time, starting tbe system
with the historical vale: for .Yat the beginning of tbe sampk period- This yields
an empirical distribution of slope estimates ihat is employ& in a variety of’
inkrence procedures3
The entire process (2500 iterations) is repeated for each of a discrete set of beta
values starting from zero. Thus, we have a differcat empirical distribution of
slope estimates for each hypothetical alternative. Wc focus on ‘nonnegative slope

‘Since the distribution of the r&da& is fiti i~foss simulatioas. as the Iruc slope c&kkttt vat&%
cbestrnittatalvaiianceofmunts inarilscr wil tht prvdkfahk var%atim k~ mturns Ifanything, this
wordd appear to make it more diikuh to lad eAknce of strottg ptcdrctability aad thus might
impart a eonsl?lvatiye hias to our lesub Likewise, with rqwd to the mx! of bias-adjusted rcsidualr
It would be interesting to exphzmz the sensitivity of inferences to altemak pmaxlurcs which
attempt to maintain a fixed total variability of mums.
I82 S.P. &&an’, J. Shankn/Joumal of Financial Economics 44 (1997) 169-203

values since the two prominent competing hypothesesconcerningpredictability,

which are market inetliciency (temporary mispricing) and time-variation in
equilibrium expectedreturns(and the associateddiscount-rateeffecton market
value),both suggesta positiverelationbetweenreturnsand the financialratios.
The setof betavaluesconsideredallowsfor the possibility that expectedreturns
arenegativewhenthe market is overvalued;the maximum betais speciRedsoas
to generatea minimum expectedreturn equal to the negativeof the sample
meanreturn. This specificationof the domain of the prior distribution is not
‘pure’ in that it makessome useof the realizeddata. Obviously, other ranges
could be considered,but someheuristicis neededto limit the analysisand this
one strikesus as reasonable.

To test+henuil hypo?hesis that d eqL‘1szero.we look at the proportion of the

256~ simuhuedsiope esumates,generatedunder the /? = 0 hypothesis,that
exceedthe historicalslope.The latter is the estimateobtainedfrom the actual
data.This givesus anempiricalpvalue for the historicalslope.The procedureis
similar to that employed by Nelson and Kim (1993),except for our use of
bias-adjustedestimatesand residuals.and two other diR&nceszthey randomly
selectan initial start up value from the unconditionaldistribution of x, rather
than usingthe initial historicalvalue(our approachis motivated by the oondi-
tionality prineipk of i&renee (Rerger,19sS.Section 1.6)).and they sample
without replaccmmt while we samplewith replaaement.
If the null hypothesisj3 = 0 is reju%d, it is of further interestto seewhether
valuesofBuptosome~ven~tive~canbe~edasw~l.Totestthis
compositenull hypothesis,we look at the empirical distribution of estimates
generated under the assumption that /I eqttab the preapccifiecl Iewd. Again, we
computethe proportion of estimatesthat exceedthe historical B estimateand
report tbis proportion as an empirical gvalut for the compositebypotbesis.
Sincelargerslopeestimatesshouldbegeneratedwhenthe truesiopeis larger,we
expectto seethe empiricalpvabres increase(weakerrejectiorl)asthe~-
ftedlevelof~imzases. Note that tbe pvalue for testing the compositenull
hypothesisthat 6 is lessthan or equalto a givenvalueisjust the Rowerfunction
evaluatedat that valueof betrm, for a testwith size(typeI error probability)equal
to tirepvalue for fJ = 0. Shenken(1987a)develops a similar approachto testing
a compositehypothesisof approximateporHolio efRciency.
It is wet1known (but sometimesforgotten) that the p-value is not the
probability that the givennull hypothesisis true(seeLindley, 1957).Rather,it is
just one ‘metric’ for assessingthe extent to which the sampleevidencehAcs
unusualunder the null hypothesis.Spt&ically, it is the probability under the
null of obtaininga historical slopeas big as(or biggerthan)that observed.The
 S.P. Kothari, J. ShkenjJounaoI of Financid Economics 44 (1997) 169-203 183

distribution of the sample statistic under the alternative plays no role in this
context.
In order to obtain probabiMes for the diRerent hypotheses, conditional on
tbe historical evidence, the Bayesian approach ,focuses on the %kelihood func-
tion’, in conjunction with prior (subjective) probabilities for the hypotheses.
With a continuous density function for the sample evidemz (here, the historical
slope), the relative likelihood of one hypothesis as compared to aDOther can
Ioosey be described as follows: it is the ratio of the respective probabilities
(under the different h.qotheses or models) of generating sample evidence within
an infinitesimal aeigh5orhood of the historical slope.
If the VAR disturbances in Eqs (I) and (2) are assumed to be jointly normally
distributed, a dosed-form expression for the iikelihood function can be obtained
(see Kandedand Stambaugh, 19!&). Here, we take a d&rent approach, intro-
ducing what we call B bootstrap likelihood, is, the proportion of simulated
samples (under a given hypothesis) for which the observed slope is in some fixed
neighborhood of the historical slope Although lacking the mathematical el-
egance of more formal Bavesian approack our strategy, like the ‘da&al
bodstrap, is simple and pragmatic, and does not requi= much in the way of
assumptions.* For example, the b&trap procedure aI- for the positive
skewness that we sometimes observe in the VAR residuala A similar approach
c&d be adapted to a variety of situations that an commonly viewed as
analyticaNy intractable an& the&~ not BmenaMe to Bayesian analysis. While
there is a literature on nonparametric density estimation, we are not aware of
any pqxm that have used bootstrapping techniq~ in the manner dthis paper.
Bootstrap likelihoods arr: computed for the same set offi values cons&r4 in
the class&d p-value analysis. These proportions are scakd so that the sum of the
likelihoods over all values of lp conside& is one. As in any Bayesian application,
scaling does not a&ct the relative tikdihoods or the associated posterior
probabilities derived from the likelihoods and a given prior. Moreover, the
scaled proportions can be interpreted directly as posterior probabilities for
the diffireat slope values when prior belie& arc uniformly distributed over the
various slopes. Although we do not claim that this is the ‘right’ prior, it provides
a convenient &&ace point for inteqxeting the data. Addirionally, if the
likelihood is (approximately) zero for the largest slope consider4 posterior
probabiirties would be unaffected by expanding the uniform prior to larger
values of beta. This is the case in mauy of our simuiatious.

*One sboukJOO(push this point loo iu. ils any boo~rap tcdmique is limitd by the inf’ormativc-
mfss oftbe obseme4l sample fmu which the simulations IVC dcvhpcd Also. in princ+ple we wouid
waattocoaditionona~~esetof~tslabisriFslurthe~~~asouroimpMied
procedure may entail wme loss of information, although it is easily exterded to acwotmodate
amditioning on several statistics
184 S.P. Kothari. J. Shanken/Journal of Finuncial Economirl 44 (1997) 169 203

We have explored the impact of varying the width of the neighborhood of the
historical slope used in computing the likelihoods. The sensitivity‘ to this
alteration is minimal (usually identical to two decimals). This robustness
is reassuring for our approach and presumably reflects the fact that the
true density function is approximately linear within the small neighborhoods
considered.

In this section we consider the role of prior information about expected

returns and the implications of this information for hypotheses about /I. In our
linear regression framework, the implied expected return or conditional mean
for a given level of the financial ratio, X. depends on both regression parameters,
z and B. Intuitively, WC tend to think about priors on these parameters by
s:nr?Ing t. i?h prior +I:&- “I!VX* :he gb.leral level of expected returns and x, as
well as the extent of variation in expected returns for given movements in .x. The
latter is our prior on fl. The prior for x is then implied by these more funda-
mental beliefs about the level and variability of expected returns.
In some Rayesian applications. researchers impose so-&led ‘diffuse* or ‘non-
informative’ priors intended to represent initial ignorana about the parameters
of a model; See Section 3.3 of Berger (1985) for a general introduction and
DeGroot (1982) for an insightful critique of the use of diffuse priors. This
attempt to achieve *objectivity’ avoids the often difficult, but rewarding activity
of assessing the economic (or other) meaning of alternative parameter values
and structuring the prior beliefs accordingly. Here, we take the view that the
prior distribution is a valuable tool for exploring the economic signibcance of
the likelihood function and that it is important to consider a range of inforrna-
tive prior b&is rather than some abstract notion of the ‘right’ prior. While this
will entail some ad hoc assumptions. we believe that the insights obtained justify
the structure adopted. Shanken (1987b) entertains a similar Bayesian approach
to testing portfolio efbciency. The limitations of diffuse priors in this context are
clarified in Kandel et al. (1995L5
Recall that z is speciIied as P - /R in our simulations. Given ( 1k this entails an
assumption that the sun& mean, $ of the return surprises is zero. This is
a natural simptifying assumption when the focus is on the slope estimator and its
sampling distribution. The condition has important consequences for analysis of
the lert# of expected returns. however. As we now argue, the assumption about
Ii amounts to an indirect method of characterizing beliefs about 2.

‘See Ma*Owitiz and Usmen (1996) fur additional discussion of thee issues in another financiaf
context.
 S.P. Kothari. J. Shank IJownal of Financial Economics 44 (1997) 169~ 203 185

Given a value of /? and the sample observations w and F, the condition ii = 0

amounts to an assertion that one’s initial belief about x is consistent with fi and
the r&tive values of the mean outcomes. in contrast, since P = x + /?K + g,
a belief that ‘ii > 0 (Ti < 0) implies that, for the given 8. the observed mean return,
7, is higher (lower) than would have been expected, given one’s prior on z and the
sample mean K. In this way, we can think of assertions about pi as implicit
statements about one’s conditional prior for ~1,given p.
This turns out to be a particularly convenient perspective, given our simula-
tion methodology and the hypotheses of interest. For example. individuab with
strong priors that expected return variation is an equilibrium response to
changes in risk would likely have strong priors that expected real stock returns
are always positivc6 On the other hand, one often sees statements in the
financial press, and sometimes in the academic literature, that the market is
substantiafly ‘overvalued’. Such individuals would presumably have strong
priors that expected returns are sometimes negative. Given the apparent diver-
sity of prior beliefs about this issue, it is interesting to investigate the conclusions
that wouM be drawn from the given empirical evi&nce for a range of beliefs
Specifying x as we have simplifies the analys& in that it allows us to formulate
the hypothesis of nonnegative expected returns in terms of an upper bound on 6.
To see this, substitute T - J?K for z in the expected return expression, x + /Xx. to
get iF+ p(x - iii). Assuming /Y ; 0. the minimum expected return in a given
sample period is F + j?(xni, -a) getting this expression equal to zero and
solving lor p yields #I0 = F,!(X - x,,, ). Thedote, the hypothesis that expected
returns are nonnegative during the given period is equivalent to j? s /&,. Fur-
thermore, the expected return coming to a slope of 2&, is - 7. IMore
generally. ifii#O, then (F-@-bg-r hq tbe analysis is modified by
substituting F - t for F in the expresstons for &,. Except where noted otherwise.
we assume that 0 6 0 in the analysis beiow.
A limitation of this approach is that it treats & as if it were an exogenous
constant. A fuller treatment of the endogeneity ofexpected returns in a dynamic
context is ieft to future research.

7. Tea!aforexpeeWlremlretnmnriatfen

This section presents bootstrap evidence for the regressions of real equai-
weighted and value-weighted index returns on B;M and dividend yield for the
entire period, 1926-91. and the 1941-91 and 1963-91 subperiods.

bi: is possible to devise models in which the expected real market pwWwn is negative IBoudoukh
et al., 1996). Since real T-bill returns excccdcd 4.5% in the deflationary period of the late ISZOS and
early 1930s. however. the negative premium required to make total exptxted real return acgatiw
durirtg that period wouid have to bc quite large.
186 S.P. Kothari. J. Shanken/Jounzal of Financiul Economics 44 (1997) 169-203

Table 5
Regmsion of one-year CRSP equal-weighted index real returns on book-to-market or dividend
yield: 1926-1991
__ ____ _c_I__-- -~_..-.--- -.-- .-- .-“.-_..----_---.----_._--______
f3 % Mean h(%) p-value LKLHD Mean h(%) pvalue LKLHD
---- ~-
Book-to-market tesults Dividend yield results
~---
0 1.88 0.001 0.001 1.23 0.127 0.041
I 2.77 0.002 o.m3 2.20 a167 0.047
2 3.83 0.004 0.004 3.32 0.213 0.067
3 4.91 0.002 0.003 4.37 0.279 0.075
4 5.91 0.007 O.&-i8 5.39 0.352 0.084
5 6.83 0.004 0.010 6.27 0.426 0.095
6 7.85 O.OlO 0.012 7.26 0.518 0.100
7 8.79 0.014 0.017 8.28 0.617 0.101
8 9.77 0.022 0.03 1 9.31 a692 0.092
9 10.81 O.OF p-036 10.24 0.77 I OB80
10 11.80 0.040 (?NG 11.10 0.8-36 0.069
11 \- -‘lr \l.< - O.W+ : 2.43 0.902 0.051
12 13.84 0.075 0.089 13.29 0.937 0.036
13 14.64 0.103 0.W 14.24 0.955 0.025
14 15.81 0.149 0.148 15.23 0.974 0.016
15 16.80 0.198 16.49 0.9R8 a009
16 17.77 0257 0.227 17.26 0.990 a005
17 _ 18.25 0.996 o.aI3
18 -. 19.30 0.998 0.002
19 - - 20.36 0.999 a001
 S.P. Korhari, J. Shanken/Jmmal of Financial Ecpunics 44 (1997) 169-203 187

the minimum expected return is zero. This ensures that the lowest implied
expected return over 1926-91 is the negative of the sample mean return or
- 1X3%, as discussed above.
‘The bootstrap standard error is 4.3% under the null hypothesis that fl = 0,
and it varies very little as the true value of /? is altered in the simulations. It is
higher than, but close to, tbe OLS standard error, 4.1%. Tbe OLS estimate is
biasedupward, however, as discus& earlier. The averap simulated vabre of the
OLS estimator given in the second cohmn tends to exoeed the true vahre by
M-1.9%, a bit higher than the 1.75% predi&d using Stambaugh’s formula.
The bootstrap revalue in the third column of Table 5, which is actually
a simulation estimate of the p-vaJue, is 0.001. This is the proportion of tbe 2500
simulated (under the null) estimates that exceed the historical slope of 20.2%.
The standard error of this estimate, based 00 a binomial analys& is the square
root of (0.001~0999~/2500, which is less than 0.001. The standard error for
a p-value do.01 (/3 = 6) is 0.002. Having strongly mjected the nuU hypothesis of
a zero slope, we would like additional information tqarding the true value offi.
Examining the p-values in column 3, we see tbat values of /3 up to 6% can be
rejectd at the 0.01 levei, whik vahres up to 10% can be r&cted at the 0.05 levd.
At this slope value, a move done-standard deviation in B/M implies an &tease
in expected return of a whopping 1000 basii points.
WenowshiCtthefocusfmm~~ngwhicbvaluePoCBcanbe~~at
conventional significanot leveks to which values have highest likelihood, amdi-
tional on the one-year histori& slope eatima&. The likdi reported in
cohunn4ofTablc5starta.0.001 foraslopeofzeroand - (almost)
monotonically to 0.23 at fl = 16% the maximum co- These likelihoods
(or posterior probabilities under the uniform prior) an computed using a neigh-
borhood consisting of points within 1% of the historical skope, and are plotted
in Fii 1 (see triangles). The values of beta with high likelihood cormspond to
huge levels of expected return variation. Under the (naive) uniform prior. most
of the posterior probability exceeds /I = 8%. which is the largest value of beta
that ensures that conditional expected returns (fitted values) are always non-
negative over the 1926-91 period.
In genera& the ratio of posterior probability for a nul! hypothesis to posterior
probability for an alternative (the ‘poste&r sjds ratio’) equals the prior odds
ratio, p/(1 - p)t times another ratio often r&erred to as the l ayes factor’ (see
Je&eys, 1957). This f&ctor is tbe weighted average likelihood under the null
bypotbesis divided by the weighted average tikelilrood under the alternative,
with weights determined by the prior. In a test of the null hypothesis tbat there is
no variation in expected returns r&ted to B/‘&4, the Bayes faclor is just tbe
likelihood at /3 = 0 divided by a weighted average of the likelihoods for positive
betas. From Fig. 1 it is clear that the Bayes factor wi’tl always be less than one
(over the range of slopes considered) and it will be close to zero for any prior that
puts substantial weight on the larger values of beta. Thus we have a sharp shift
188 S.P. Kolhari. J. Shonken iJournu1 of Finonciol Economics 44 (1997) 11% 203

in beliefs away from the hypothesis /3 = 0, particularly for those individuals who
believe that expected returns are sometimes negative.
The bootstrap evidence from the regression of equal-weighted index returns
on dividend yield is reported in columns 5-7 of Table 5. The maximum /I values
considered correspond to a minimum expected return of - 15.3% in each case.
The range of slopes for B/M is smaller than that for dividend yield since the
minimum value of B/M is more extreme whea measured in units of standard
deviations from the mean. The bootstrap standard error is 4.9% under the nufl
hypothesis fi = 0. It is higher than, but again close to, the OLS standard error of
4.8% in Table 2. The OLS bias (difference between the first two columns) ranges
 S.P. Krdwi. J. Shot&en, Journal oj Financial Economics 44 (I 997) 169 203 189

from 1.2% to ! 4%. comparable to the 1.3% predicted using Stambaugh’s bias
formula. The bias is roughly 20% of the value of the historical slope, 6.7.
The bootstrap pvaluil for @ = 0 is 0.13, close to the pvalue of 0.12 based on
the t-statistic of 1.39 in Table 2. Although we cannot reject the null hypothesis of
a zero slope at conventional levels. the likelihood function in Fig. I (see squares)
rises ini:ially, peaks at /3 = 7%. and declines steadily after that. Thus, the Bayes
factor will be less than one, i.e, will favor the conclusion that expected returns
do vary, except for priors that place most of the weight on very large values of
j!I(greater than 11 o/6) Therefore, anyone who believes that expected returns were
positive over the pziod 1926-91 (B 5 9%) will become more confident that
expected returns vary with dividend yield. The maximum possible shift in odds
is by a factor of 2.5 = O.lOl~WMl. the ratio of the maximum hkelihood to the
likelihood at zero. On the other hand, an investor with prior beUs heavily
weighted on #I values greater than 11% will become less confident that expected
returns vary with yield. This is a relative statement, though; such an investor will
still be confident (high posterior probability) that /3 # 0, but this will be due to
the prior dominating the sample evidence.

7.2. Vaiue-weighted rtwm rqpssed on B,“Af rw di&kvtd yield

Bootstrap evidence for the l:alue-weighted index is given in Table 6. The

bootstrap pvalws for /II = 0 ale close to 0.02 for both B,‘M and dividend yield,
rejecting the null of no expeclcd return variation. The likelihood functions
plotted in Fig 2 tell a subtler story, however. As earlier, the B/M likelihood
function never drops below the fl= 0 likelihood over the range of slopes
considere& although it does turn downward. Thus, the evidence implies a shift
in beliefs away from the hypothesis of no expected return variation for the entire
class of priors consider+. In contrast. while the likelihood function for dividend
yield generally favors vitive values of& an investor with a prior concentrated
on very large values of /I would come away from the evidence less confident that
expected return varies with dividend yield. This follows from the fact that the
likelihood function for dividend yield eventually drops below the likelihood for
fl = 0, as earlier in Fig. 1.

7.3. Suhperiod ana!sses

This section discusses bootstrap simulation results for the 1941-91 and
1963-91 subperiods. The Ml-91 subperiod excludes the Great Depression
period of high return volatility; the more recent ml-l%2 subperiod is of
interest because it coincides with the period over which much crossaectional
examination of book-to-market ‘ratios has been undertaken.
‘Not surprisingly, given the smaller time-series sample and greater persistence
in the independent variables over the subperiods. the estimated slope biases
190 S.P. Kolhari, J. ShankeniJournal of Financial Economics 44 (1997) 169-203

Table 6
Regression of one-year CRSP value-weighted +dex real returns on book-to-market or dividend
yield 19261991
--I__-.-__--_- .-.- ._--.- -- ..- ~_- .--.- - _-- -.-.-- -.-_, ..-- __._.-.--._-._-l__
p % Mean b( %) p-value LKLHD Mean h(%l pvalue LKLHD
--------- -----II__
Book-to-market results Dividend yield results

0 1131 0.016 0.013 0.94 0.022 0.020

1 2.43 0.032 0.023 1.84 0.043 0.029
* ~ 3136 0.050 0.035 ‘86 0.076 0.047
3 4.41 0.085 0.050 3.90 0.140 0.067
4 5.35 0.134 0.073 4.89 0.212 0.090
5 6.36 0.203 0.103 5.90 0.313 0.115
6 7.40 0.306 0.129 6.72 0.417 0.131
7 8.35 0.429 0.156 7.81 0.571 0.139
8 9.39 0.5n 0.155 8.91 0.720 0.122
9 10.35 O.7? I 0.!46 9.90 0.836 0.0%
IO 1 16 nr.$ri Q 112 10.82 0.912 0.068
!I i i.92 0.965 0.041
12 12.79 0.987 0.023
13 13.85 0.9% 0.09
14 I4.W 0.998 0.003
15 15.94 l.atO OBOI
16 16.86 l.alO O.OlX)
.~ ._.
Che-year returns are regrwd 011 Lwginningd-yrw B.M or dividend yield (scaled by standard
deviation) to obtain the historical slope estimate. and a first-order autoqn+on is estimaiai tar
B/M. Bias-adjustadastimatcsdthercgr&on parameten are used to cated adjusted regndon
residuals. Given a by~othatical value d p, the return regnshn siopc, and the bias-adjusted
autcrcwreLation cstinwe. adiciai time series of annual returns and B, M or dividend yieki ratios
(7 - 661 arr generated by randomly sampling from the joint disttibution Wendar year Pairs) of
adjusteddwlrr
ftxe (anificid) returns are regrewd on the tartiticialr B+M 01 dividand yield ratios to obtain an
estimate of @. The proad~ is rePeated 2500 times and b. tbc average of Ibe regression co&&nt
escimales. iseimpkue&
The bootstrappvalue for a given /I is the proportion of the 25OOcstimatea that exa)od the historical
slope. LKLHD (the bootstraP iikdibuod) is the scaled proportion of the Zsoo estimates that lia
within a smat! interval antered at the historical slo~c The proporrions arc~40thatthesumof
likctihooQoverall~sisnne.

from Eq. (3) are larger for the subperiod estimators. For example, the simulated
bias for the B/M slope (not rqorted in tables) exceeds 4.0 for both indexes over
196391. &s-adjusted t-statistics are computed by subtracting the simulated
mean value (under the null fi = 0) from the estimator b and dividing by the
standard deviation of the bootstrap slopes.
Table 7 presents bootstrap p-values for /? = 0, along with pvalues based on
the OiS r-statistics and bias-adjusted t-statistics. ksults for 1941-91 are given
 S.P. Kothori. J. Shanken/Joumai of Financial Eronomics 44 (1997) 169 -203

in panel A, while results for 1963-91 are in panei B. As expected, the bias-
adjusted pvalues are often much larger than the conventional CXS pvalues.
However, when the values are relatively low, the bias-adjusted pvaks are
smaller than the bootstrap p-values. This apparently reflects nonnormality of
the bootstrap distribution for the slope estimator, with the bootstrap having
a fatter upper tail. For example. the adjusted p-value is OJlNi in the equal-
weighted dividend yield case (Ml-91), while the bootstrap’pvalue is 0.048. The
binomial standard errors are 0.002 for the 0.00s pvafue aad 0.004 for the 0,048
p-VillUe.
We focus on the more conservative bootstrap pvalua. In the post-1940
period, the hypothesis of no related expected return variation is rejected at the
132 S.P. Kothari. J. Shanken /Journal 01 Financial Economics 44 (19%‘) 169. 203

Table 7
P-values for the null hypothesis fi = 0: subperiods 1941 91 and 1963-31
-- _____---. _-___--__----
index Financial ratio OIS Bias-adjusted Bootstrap

Panel A: 1941 91

Equal-weighted fSook-to-market 0.002 0.014 0.040

E&al-weighted Dividend yield 0.001 O.OOS 0.048
Value-wn’ghted Book-m-market 0.03 I 0.127 0.156
Value-weighted Dkdend yield 0.001 O.lUl 0.024

Panel B: 1963-91

E&p&weighted Book-to-market 0.036 0.295 0.250

E4pd-WCigkd DiVidcnd,yidd 0.001 0.012 0.023
Value-weighted Book-to-market 0.156 0.629 0.571
Vahu-weighted Dividend yidd 0.008 0.102 0.115
..- _- ..-. I-
F~xII-ud~’ ~EC?index IS :h- CWP equal *+ XI arnual real return inclusi. z of dividends from
April tti~y~ f to hla~b Oc yur f + I.
V&e-wcightnf rndex is tbc CRSP value-*eighted annlrztl red return inc!Gvc of dividends fron,
AprilofyearrtoMarchofyurr+l.
Book4o-markd is the ralio of the book value per share at the end of year r - I of the stocks in the
Dow Jones hdusirid Average to the I%w ha Induplrial Awragc zt the end of March of year t.
Equxr-~~(eddividadyiddkfhenriooCdividcn&rpzidfronAprilofymrt-I~oMard,of
yew I IO the aetmwdatcd valwe ofoacdobr invcstaj in tbc CRSPcqual-weighted index exclusive of
divi&~&foroneycareedingonMardt31ofy~~r.
V~uc-~rddividadyidd~tbcntioddivikadrpiridfromApritoCyearr-ltoMarebd
year I to the cwxtumbtal vplucofone ddlar iavcs&d in tbc CRSP vabc-eighted index exdusiw of
divideads l&r l-year ending 08t Mat& 31 Or year 1.

0.05 I+, except far the combination of value-weighted index and ?M. The
smallest pvalue is 0.024 for the regression of value-weighted returns on dividend
yield. In the past-1962 period, rejection at the 0.05 level is only observed for the
eqtutCwe&hted index and dividend yield.
The bootstrap likelihood functions provide additional insights into these
results as well as the potential contrasts between classical and Bayesian
infmnce in all but one case, an investor who 6rmly believes that expected
returns are never negative will come away from the regression evidem~ with
greater conti that expected returns vary with B/M or dividend yield. This
is true .~ven for the post-l%2 scenario with B/M and the equal-weighted
index (with bootstrap pvalue 0.2Sk although the maximum shift in odds
(Bayes factor) is only 1.7 in this case. On the other hand, in most q
the direction of the shift in beliefs for an investor who firmly believes that
expected returns are sometimes negative depends on the specifics of their prior
distribution.
 S.P. Korhari. J. Shanken ‘Journal of l;inonciai Economics 44 (1997) 169-203 193

The post-1962 likelihood function for the equal-weighted index and dividend
yield rises steeply and stays well above the likelihood at j3 = 0 for the entire range
of j? value& This will be viewed by ail investors (for the class of priors considered)
as evidence in support of time-varying expected returns. At the other end of the
spectrum, the value-weighted, B/M, post-1862 iikelihood function for the value-
weighted index and B/M steadily deciines as 6 increases, shifting all priors toward
the con&&n that B/M does not track variation in expected mturns for the
v&re+veighted index. One final case wortb highlighting is the post-1962 scenario
for the value-weighted index and dividend yield. Here, the likelihood function
drops below the likelihood at fl= 0 only at the largest value co&&red (j? = 9%).
Thus vittuaUy all investors considered wiii view the evidence as supporting
a relation between dividend yield and expected return, even though the c&s&al
test fails to mject :he null hypothesis of no relation at the 0.10 level.

8 Tests for momaegatire expmed wmms

The regre&on evident: examined above suggests considerable variation in

expected returns as a function of both B; M and dividend ytetd. ktg. 3 plots the

Fig. 3. Expected equabeightcd index returns: 1926-1991

Expeaed returns arc fltcd vows from the rcgessbn of real returns oa prior book-to-market ratio
or dividend yield over the 1926-1991 perio& The fitted values are evaluated al the maximum
EkeMwud beta v&es. 16% for book-to-nwket and 6% for dividend yield. with the interczpts
spdied so as to equate the avemp expected returns to the sampk mean return.
194 S.P. Kothari. J. Shunken/Jourwal of Financial Economics 44 (1997) 169-203

Fig. 4. Expedcd vaiuc-wciphtd index rctums 1926-1991

Expracd returns ate fitted rdues from the mgrcsion of real mwns on prior book-to-market ratio
or lividend yi&l over tb 1926- 1991 period. l’be fitted values are cvaloated at tlw maximum
lidibood beta values. 16% for both book-to-markci and divided yiekf, with the interc+x
xpcciliod so as to cqwtc tbc tlKwgc rxpxtcd rcwm.5 to tbc xanlpk mcatl rctum.

1926-91equal-weightedexpectedre~ums(fitted values)usinghistorical BjM or

dividendyield and the maximum likelihood slopevalues/?= 16% and fi = 7%,
respectively.Consistent with the market being predictably overvalued,the
expectedreturns basedon BfM are negativefor sever8)years at Both the
beginningand end of the s8mpk and two ye8rsin between.The most neg8tive
expectedreturn is - 14.5%in 1929whenthe market valuefor the Dow 30 is
about 3.7(l/0.27) times book value. Expectedreturnsbed on dividend yield
are 8lwap positive, however. Vahte-weightedindexexpectedicturns areplotted
in Fig 4. Here,negativeexpectedreturnsbasedon B/M aresmalkr in magni-
tude 8ad &Ilit4?d t0 the 192&30PlZi’iOd.
Perhapsas impktusibie8s nCgatiVe expected returns,at hzast to 8 believer of
market efB&ncy, are the Iargepositive expectedreturns impiied by the high
B/M vaiuns,particu$rly from the mid-1970sto the early 1980s.B/M valuesin
this period imply expectedreal returns ranging from 20% to 50% per year.
While theseratesareextremelyhigh, an interpretationthat the market wason
the brink of’a near-mrmupwardcormctiou is too simplistic Anyoneattempting
to c8pit8.b on the bm.krvalu8tion’ in the 1970swotdd have had to endure
8 prolongedwait beforethe market beganto rise in the early198os.A similar
statementc8nbe maderegardingthe market’spetformalwxsincethe late 19&os.
 S P. Kohari, J. Shanken i Journal c/Financial Economics 44 (I 997) I69 -203 195

The Dow Jones B/M has been about 0.4 during this period, fairly low, by
historical standards. However, expectations of a low market return have been
foiled by the stellar market performance in the 1990s to date. The Dow Jones
B/M stood at its historical lowest, 0.27, on April 1, 1995, but the market
performance since then has been one of the best in the post-Work! War II
period. pe Dow Jones B/M is currently (August 1996) only 0.23.
In the remainder of this section, we consider formal tests of the hypothesis
that expected real returns are always non-negative over the given period of
interest. By the law of iterated expectations, if expected returns are non-negative
conditional on all in’ormation availabIe at each point in time, then expected
returns must also be non-negative conditional on any subset, in particular when
conditioning on B,‘M or dividend yield.

From Table 5, we see that the hypothesis that expected returns are non-
negative over the 1926-91 period is rejected at the 0.02 Ieve! (p-value for j? 5 8)
for B/M and equal-weighted index returns. The corrqumdiag pvaiue for B/M
and value-weighted index miums in Table 6 is about 020 (for jf I 5). Thus, we
cannot rejeck at conventional signiticance &eve4 the hypothesis that the nega-
the fitted vahres for the value -weighted index, in Fig. 4, am due to error in
estimating /I. There is no evidence of negative expected returns in the dividend
yidd results.
As explained in Seaion 6 these non-negativity tests implicitly assume that the
sample mean of the return disturbances+ i& is zero for the given period. We now
compare this test to the conventional regmssion procedure for making infer-
ences about a conditional mean. The eslimated expected return @ted v&e) at
the minimum sample value of B/M (27.2% for 1929) is - 22.3% for the
fzqual-weighted index. The corresponding standard error, based on the usual
regression formula, is 17.3%. This yields a t-statistii of - 1.3 and a pvaiue of
0.10 for the hypothesis that the minimum expected return is positive over the
1926-91 period.
The hirly large increase in p-value (0.02 to 0.10) re&cts the fact that the
conventional procedure incorporates uucertaint~ about the sample mean distur-
bance term, whereas our ~-based test con&ions on a t&&about tbe magnitude
of i&l Due to the substantial variability in return surprises, the conventional test
for non-negative expected returns is not powerful. Conditioning on the mean
disturbance permits us to concentrate on the slope cxxfkieut and the impha-
tions of time variation for nonnegative expected returns, holding the average
level of expected return constant at the sample mean. since we focus on
a narrower issue, the power of our test is, not surprisingiy. enhanced.

‘A more formal statistical appendix is available from the authors on request.

196 S.P. Kothari, J. ShankenlJoumal oJ’Finrmcial Economics 44 (IWi) IS-- 203

Now, suppose that (relative to one’s priors) the data indicate that the mean
return surprise, ri, is positive.8 For example, the literature on the equity premium
puzzle(Mehra and Prescott, 1985) suggests a lower prior expected real return on
the equal-weighted index than the sample mean of 15.3%. Alternatively, one
might believe that the observed sample of US. returns is subject to a selection
bias related to survival and grdwth of equity markets at the country level
(Brown et al., 1995).
Suppose, far exarnk~ that half of the mean return is viewed as an ex post
surp* i.e, H = 7.65%. Given the analysis in -ion 6, this has the eflkct of cutting
in half the maximum value offi copsistent with non-negative expested tiurns The
associated p-value (for /I 5 4) is 0.002 as compared to 0.02 (for /I I 8) earlier.
Naturally. incorporating a belief that the return surprises are positive, on avm
leads to a stronger rejection of non-negativity. since our belief about the general
level of expected returns is lowered relative to that of the previous scenario.

X2. Bqwzsian tests

We now turn to Bayesian tests of the nonnegativity restriction. The equal-

weighred B,‘M regression is examined first. In order to analyze the expected
return hypothesis in a manageable way that is readily communicaterl to a var-
iety of ti some additional structure is needed. We consider priors that
assign probability p to betas from zero to 8% and 1 - p to betas from 9% to
16%, the prior probability distributed uniformly within each subset. With this
prior, p is the probability for the composite null hypothesis that expected returns
are always non-negatives conditional on this hypothesis, no variation in
expected returns (#I = 0%) is considered as plausible as anything up to an 800-
basis-point (fi = 8%) variation in expected returns for every one-standard-
deviation change ia B/M. Prior weight on beta values between 9% and 16%
entails a belief that expected returns can be negative (i.e., when B/M is relatively
low) and that expected returns vary greatly through time.
The assumption that probability within each subset is uniformly distributed is
adopted for simplicity. While it violates desirable conditions like continuity of
the prior density, we believe the general conclusions that emerge are su@ciently
rdbust that the benefits of simplification outweigh the costs. Given the uniform-
ity assumption, the Bayes factor $ just the ratio of average likelihood under the
null to average likelihood under the altemativc, which is imlependcnt of p. The
Bayes factor for our equal-weighted index B/M regreGon is 0.086. Thus, in light
of the B/l&l eGdencz there is roughly a 12-&A shift in odds against the hypothesis
that expected returns are atways non-negative over the period 192691.
In Fig. 5, we plot the posterior probability that expected returns are always
nonnegative as a function of the prior probability p. The *no-change’ line with
a slope of one is a natural benchmark for which the prior and posterior
probabilities are equal. Thus, the straight line in Fig. 5 corresponds to a scenario
 S. P. Korhari. J. Shanken ‘Journal qf Financial Economics 44 (!997) 169-203

1.m

0.90

0.80

0.70

OM

oxl

OAO

O.Xl

0.20

QIO

om

Fig 5. Posterior probability that cxpeded real rcturxs arc ~-negative 1926 1991
Poskrior prob&ilitics arc derived from tk like&xxi timctionr plotted IB Pigs. I and L with prior
distributiom spedid over the ranges of beta values in those Crgurcs. Beta r&es in the first half of
each range aIri cxuwistcnl with nonlltgrtivc expected ITtumi. v-h& betas in tbc z3cxmod half yield
negative expeucd mtums at some point in the 1926-1991 period The prior distributions arc
uniformly distributed within each MF. prior probability is the wet&t assigned to the first ItaIfofthe
b-raagp.

irt which the Bayes factor is one. The low va!ue of the actual ibyes factor in the
equal-weighted B/M case ensures that the posterior probability curve iies beiow
the no-change tine for p between zero and one. This means that. regardless of the
prior (p # O,l), one ends up less confident that expected returns are always
non-negative (i.e., 0 I /I I 8%). In particular, an individual who is initially
198 S.P. Kofhari, J. Shanken/Joumal of Finaaciai Economics 44 (1997) 169-203

uncommitted @ = 0.5) with regard to the hypothesis that expected returns are
non-negative has posterior probability 0.08, while an individual with prior
confidence in the non-negativity condition, say p = 0.8, has posterior probabil-
ity 0.26.
Now, as we did for the classical test of non-negativity in the previous
subsection,we considerthe alternative assumptionthat iJ, the mean surprise
componentof return, is 7.65%. As before,the maximum /I consistentwith
non-negativeexpectedreturnsis reducedto 4%. In addition, the rangeof frs
entertainedas plausiblea priori is likewise cut in half,with a maximum fl of 8%.
At this value,the most negativeexpectedreturn overthe 192691 period is now
- (F-‘ii)=- 7.65%.Given the likelihoods reportedin Tabie 5, the resulting
Bayesfactor(ratio of averagelikelihoodsfrom 0 to 4 and 5 to 8) is 0.226,almost
threetimes the Bayes factor obtained under the si = 0 assumption. The corres-
poadingposteriorprobability for non-negativeexpectedreturnsof the l corn-
mitted’ (I, = 0.5) investor is now 0.18. as comparedto 0.08 above.Truncation
:td\. a mLl;n?al Pffr?! ia *&i; rec;LIx.
The increasein posteriorprobabihtymay be surprising,sincetheclassicaltest
rt$cctd non-negativitymore stronglywhen U = 7.65*/s.The reasonis that the
prior associatedwith I?= 7.65% eliminates the weight previously placed on
the very largevaluesof fl(> 8) that haveextremelyhuge likehhood,given the
historical slopeof 20.2%(seeFig. I). Thus, the increaseis a consequence of the
changein prior implied by the given beliefabout Ti (maximum 8 reducedfrom
16% to 8%), in conjunction with the particuhtr behavior of’ the hkelihood
bmction in this example.
in the value-weightedB/M case,the posteriorprobability curve again lies
belowthe no-changetine,despitethe relativelylargepvalue of020 (for /?s 5%
in TaMe 6) fof the null hypothesisof non-negativeexpectedreturns. The
posteriorprobabilitiesarekss extremethan thosefor the equal-weightedindex,
however.For exam& an observerwith p = 0.5 comesaway from the B/M
evidemzwith posteriorprobability 0.25that expectedreturnsarenon-negative.
Posteriorprobability cutvesfor dividend yield in Fig. 5 he abovethe no-change
line, mflectittg&teased confidencein the non-negativityhypothesis.Curvesfor
the 1941-Wsubperiod,given in Fig. 6, all heabovethe no-changeline as we!1

8.3. Testswith truncath

One view of the 1933outheris that i: is an observationthat just happenedto

occurin oneyearout of 66in our sample,but which hasan enante@opuiation)
probabihtyfar Iessthan this From this perspective,conventionalweightedleast
squaresptoceduresdo not adequatelyaddressthe proMem sincethey still give
too much weight to the 1933data point. To gain additional insight into the
problem,we rerun the 1926-91B/M bootstrapanalysiswith 1933truncated,as
discussedearlier in Section3.
 S.P. Knthari, J. Shonken~Jo~rnal of Financial Economics 44 (1997) 169-203 199

l.CQ

0.90

om

am

0.60

o.50

04

OS

o.20

a10

a00

F*tX Post&or pmbability that crpadcd teal tcWntb ate nonacyUrcc: IW-1991
PostetCprobabiiities on derived ftuttt the IikeIibood functions aad prior &tributiot~ spedal
overthecomspondiagraagsofbctaval~Becav~afintfwhr;t~oreachoreach~arrcorYsirteot
witb non-negative expdcd returns. while betas in the second ltd+d ibegMive expatcd teturtt5 at
sotne point in the WI-1991 period. The prior distribrttions ate uttironnly distribulcd with crh
Ita& prior probabiiity is the weight assigned to the lirst half of the beta range.

With the equal-weighted stock in&z, the bootstrap pvalue for the null
hypothesis that expected returns are unrelated to B/M @ = 0) rises to 0.005 with
tmncatioo, from G.001 earlier, the pvalue for the hypothesis of non-negative
expected rptums (6 I 8) increases to 0.084, from 0.022 when 1933 is included
(Table 5). Corresponding p-values for the value-weighted index are 0.045 (0.016
earlier) for no relation. and 0.27 (0.20 earlier) for non-negative expected returns.
Perhaps more informative, given the limitations of p-values. are the posterior
probabilities. Now, an uncommitted, i.e., p = 0.5, observer comes away from the
equal-weighted B/M evidence with posterior probability 0.14 (0.08 earlier) that
expected returns were non-negative over the 192691 period. For the vafue-
weighted index. the posterior probability is 0.34 (0.25 earlier). Thus there is still
a shift in beliefs, albeit a weaker one. away from the non-negative expected
returns hypothesis.

9. Summaryad coaehasioas

We find reliable evidence that both dividend yield and B,,M track time-series
variation in eawted real one-year qtock returns over the period 1926-91 and
Lb< sub~“-~iJd ??‘! 141 The P X r&lion is stronger over the full period. while
the dividend yield relation is strongerin the subperiod.
Jhe estimated 1926-91equal-weightedreturn slope on B/M implies chat
expectedreturnmovesby an astounding20percentagepoints(18bias-adjusted)
for a one-standard-deviation drarrgein B/M. The coefRcientis so large that
implied expectedreturnsare sometimesnegative.particularly in the late 1920s
whenthe B/M ratio is relativelylow. The resultsarequite sensitiveto the 1933
data point, however,when both B/M and market index returns attain their
maximum values.Using a +truncation’method that reducesthe impact of this
outher. the pvahte for non-negativeexpectedreturns is 0.08 (0.02 without
truncation).ASthoughthe pvalue of O.Ogmight be interpreted by some as
‘insignificant’,the posteriorprobability for an investorwho assignsprior pro&
ability 0.5 to the hypothesisof non-negativeexpectedreturnsis only 0.14(O.Orr
without truncationt Resultsfor the vahte-weightedindex and B,/M arequalitat-
ively simihtr, though the &i&s in beliefsare far lessdramatic.
Thus,theB/M resultssuggestthat expectedreturn variationover the 192691
periodwasnot drivenentireiy by equilibrium changesin compensationfor risk.
Rather,It appearsthat the market may havebeeniocfficieat,particularly in the
late 1920sand early 193oaa period of greateconomicvolatility. Ihe stronger
resultsfor the equal-weightedindex, which is infiueneedmore by small-firm
returns,is consistentwith this conclusion,although greatervariation in risk-
rehcd predictabiity is also piausiblefor smallerfirms.
The market ineffciency conclusionshould be temperedby severalobserva-
tions. First, them is the familiar elementof data mining which implies that the
sign&ance ofextremerest&sis overstated,althoughby how much it is difhcult
to say.Whiie the6nancialratiosconsideredherecan bemotivatedtheuretically,
dividend yield is examinedin part becauseof its prominenceas comparedto,
say,earningsyield in pas:time-seriesstudies(elg.Fama and French,1988).B/M
 .s.i? Kothari. J. ShankenlJomnal of Fincmcial Economics 44 (1997) 169-203 201

is considered primarily hecause of its recently acquired celebrity status in

explaining cross-sectional stock return variation, although the extent to which
this biases time-series results at the market level is less clear. These concerns and
the fati that the forecasting power of B/N and dividend yield varies consider-
aMy over dif%rent subperiods give further credence to t!re idea that data mining
&&atiUOS should teIllpcr One’s Bt of the value of t!tese ratios in
making futUrC iOVCSttOCOtdecisions
The &&kOd Yk!d S!Op esthetes for the 1926-91 period and al! of the
estimates for the 1941-91 subperiod are IIXOR ‘reasonable’ than the B/M results,
hut still srsbsrantia!, implying expected rCaum movements from three to eight
percentage points for one-standard-devisation changes in the financial ratios.
w estjsx-tates all result in varying degrees of inrfeus4 contidence in the
proposition that expected returns were Rever negative. While the considerable
estimated variation in expbcted returns might he di!!!cult to recxmci!e with
market dticjeucy~ the hypothesis that the slope is greater than t!trae is never
med at the 0.05 kvd. Definitive statesnents concerning the extent to which
d-tad variation in t qectu! returns is related to risk or systematic mispric-
kg (or both! RX!tlirC further analysis.
one step toward reconciliation with srtarkct e&iency mig!tt bc hased on
& argument of Brown et a!. (1995k who em t!te rok of survivor hiascs,
even at the country !eW!. IruSe arguments gain credibility in that t!xe evi-
w of inefficieacy is tied tc a historic period of considerahk uncertainty.
However, urbi!e survival of the U.S. market could impart an upward hias to the
-on s;Eope coefWent, it might a!so &as tbe interctpp uparanl. Adjusting
for the e@Ct Of SlUViVOr bias 00 the Slope WOUld t&uOe the statiStiCi! signi-
ficanee (larger p-value) of our evidence of oegative expected returnq but the
inten;ept &as would imply a stronger rejection of noo-neg+ivity, as shown in
sactioo 8.1.
violatjon of the homoskedastic linear rvqmssioo speci!ieatiou used in most of
our anal+ might give a misleading impression as to the likeli!rood of negative
expected t-eturns, but our initial analysis suggests otherwise. Tbe first-order
autorclpr#isive pr- postulated for the f$atiial ratios could easi!y be
genera!- although we suspect this would have !ittle impact on tbe main
~!usio~s- It worth! also he interesting to compare the performance of the
bootstrap likelihood methodology with tlae bkellbood function generated under
t!te assumption of hivariate normality of the vector automgressive disturbances
tsee ~&t and Stambaugh, 1996). Although extension of the latter approach to
overlapping multiyear returns would appear di!Iicult, use of the bootstrap
methodology in tbis context is straightforward and should provide further
insights jnto the behavior of expected return variation.
10 &j&30 to our empirical conclus!cxns, we note several examples of the
limited jnformativeness of standard p-value analysis and the benefits of explor-
ing the likelihood function. One interesting scenario illustrates the important
202 S.P. KotAori, J. Shanken fJoutna1 of Financial Economics 44 (1997) 169-203

role that prior beliefscan sometimesplay in interprcting data.An investorwho

is confidentthat expectedreturnsarealwayspositiveviewstheregressionresults
as supportingthe hypothesisof expectedreturn variation, while an investor
strongly inclinedto believethat expectedreturnsare sometimesnegativeviews
the regressionas favoringthe constantexpectedreturn conclusion.In another
scenario, investorsspanning3 wide variety of prior beliefsview the regression
evidenceas supportinga relation betweendividend yield and expectedreturn,
eventhough WC,fail to rejectthe null hypothesisof no relation at the 0.10ievei
(Fvaiue 0.12).
Finalfy, we notethat the bootstrapapproachto likelihood/Bayesiananalysis
is quite flexibleand could prove usefulin a varietyof empiricalcontexts.This is
likely to be thecasein accountingand corporatefinanceapplications,wherethe
variables of interest are often far less well-behavedstatistically than stock
retums.6

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‘The bootstrap programs usixi in our ~putations were written in Gauss and am available on
req-
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