This paper summarizes earlier research On the sources of variation in
monthly U.S. stock returns in the period 1927-88. A log-linear model is
used to break unexpected returns into changing expectations about future
dividends and changing expectations about future returns. Even though
stock returns are not highly forecastable, the model attributes one-third
of the variation in returns to changing expected returns, one-third to
changing future dividends, and one-third to the covariance between these
components. Changing expected returns have a large effect on the stock
market because their movements are persistent and negatively correlated
with changing expected dividends.
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