Stock return predictability and cyclical movements in valuation ratios

According to present-value models, financial valuation ratios should predict future stock returns or cash flows; however, when tested empirically, these ratios show little power. This paper develops insights into stock return predictability and reconciles the contradictory findings about the information provided by financial ratios. We decompose a financial ratio into a slow-moving component that reflects the time-varying local mean, and a cyclical component that reflects the transitory deviations of the ratio from its local mean. The cyclical components deliver substantially improved in- and out-of-sample forecast gains of stock returns and cash flows relative to the original financial ratios and the historical average benchmark. Conversely, the slow-moving components fail to predict returns, and therefore they are found to disguise the predictive information contained in the financial ratios for stock returns and cash flows.