Forecasting Japanese Stock Returns with Financial Ratios and Other Variables
This paper extends the previous analyses of the forecastability of Japanese stock market returns in two directions. First, we carefully construct smoothed market priceñearnings ratios and examine their predictive ability. We find that the empirical performance of the priceñearnings ratio in forecasting stock returns in Japan is generally weaker than both the priceñearnings ratio in comparable US studies and the price dividend ratio. Second, we also examine the performance of several other forecasting variables, including lagged stock returns and interest rates. We find that both variables are useful in predicting aggregate stock returns when using Japanese data. However, while we find that the interest rate variable is useful in early subsamples in this regard, it loses its predictive ability in more recent subsamples. This is because of the extremely limited variability in interest rates associated with operation of the Bank of Japanís zero interest policy since the late 1990s. In contrast, the importance of lagged returns increases in subsamples starting from the 2000s. Overall, a combination of logged price dividend ratios, lagged stock returns, and interest rates yield the most stable performance when forecasting Japanese stock market returns.
In our previous study (Aono & Iwaisako, 2010), we examine the ability of dividend yields to forecast Japanese aggregate stock returns using the singlevariable predictive regression framework of Lewellen (2004) and Campbell & Yogo (2006). This paper continues and extends our earlier efforts in two respects. First, we examine the predictive ability of another popular financial ratio, namely, the priceñearnings ratio. This is motivated by the fact that some studies using US data (for example, Campbell & Vuolteenaho, 2004) find that smoothed market priceñearnings ratios have better forecasting ability than dividend yields. We carefully construct Japanese priceñearnings ratios following the methodology pioneered by Robert Shiller (1989, 2005) and examine their ability to forecast aggregate stock returns. We find that the predictive ability of the price dividend ratio is consistently better than that of the priceñearnings ratio.