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FINANCIAL RATIOS TO PREDICT THE STOCK RETURNS OF TRADING AND SERVICES PUBLIC LISTED COMPANY IN MALAYSIA Nursyamimi Huda Binti Bohari HF 5681 Rl5 N974 Bachelor of Finance (Honours) 2012 1012

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Page 1: financial ratios to predict the stock returns of trading and services

FINANCIAL RATIOS TO PREDICT THE STOCK RETURNS OF TRADING AND SERVICES PUBLIC LISTED COMPANY IN

MALAYSIA

Nursyamimi Huda Binti Bohari

HF 5681 Rl5 N974

Bachelor of Finance (Honours) 2012

1012

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Pusat Khidmat Maklumat Akademi UNlVERSm MALAYSIA SARAWAK

FINANCIAL RATIOS TO PREDICT THE STOCK RETURNS OF TRADING AND SERVICES PUBLIC LISTED COMPANY IN MALAYSIA

P"~liiMIlili 10002.45012

NURSYAMIMI HUDA BINTI BOHARI

This project is submitted in partial fulfillment of the requirements for the degree of Bachelor of Finance with Honours

(Finance)

Faculty of Economics and Business UNIVERITI MALAYSIA SARA W AK

2012

Page 3: financial ratios to predict the stock returns of trading and services

Statement of originality

The work described in this Final Year Project, entitled "Financial Ratios To Predict The Stock Returns of Trading and Services Public

Listed Company in Malaysia" is to the best of the author's knowledge that of the author except

where due reference is made.

(Date submitted) (Nursyamimi Huda Bohari) 21963

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ABSTRACT

FINANCIAL RATIOS TO PREDICT THE STOCK RETURNS OF TRADING

AND SERVICES PUBLIC LISTED COMPANY IN MALAYSIA

By

Nursyamimi Huda Binti Bohari

This research was carried out to study whether the financial ratios can predict the stock

return of trading and services public listed company in Malaysia for the period from

January 2001 to December 2010. Three financial ratios have been selected which

include dividend yield (DY), earning yield (EY), and book to market ratios (BIM) that

have been documented to predict stock returns. This study applies fixed effect model

techniques to estimate the predictive regressions in the form of simple and multiple

models of panel data sets. From the findings, the financial ratios can predict stock return

as book to market ratio has a higher predictive power than dividend yield and earning

yield respectively. Hence, book to market ratio playa significant role in capturing strong

variation in stock returns. Furthermore, financial ratios are able to develop stock return

predictability when the ratios are combined in the mUltiple predictive regression models.

For future study, it is recommended to use more than 10 years and adding more

variables to get a more reliable data and strong results.

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I

ABSTRAK

NISBAH KEWANGAN UNTUK MERAMALKAN PULANGAN STOK DAGANGAN DAN PERKHIDMATAN SYARIKAT YANG TERSENARAI DI

MALAYSIA

Oleh

Nursyamimi Huda Binti Bohari

Kajian ini telah dijalankan untuk mengkaji sarna ada nisbah kewangan boleh meramal

pulangan saham syarikat perdagangan dan perkhidmatan awam yang disenaraikan di

Malaysia bagi tempoh dari lanuari 2001 hingga Disember 2010. Penyelidik memilih tiga

nisbah kewangan termasuk hasil dividen (DY), hasil pendapatan (EY), dan buku kepada

nisbah pasaran (B / M) yang telah didokumenkan untuk meramalkan pulangan stok.

Kaj ian ini menggunakan teknik model kesan tetap untuk menganggarkan regresi

ramal an dalam bentuk model yang mudah dan beberapa set data panel. Daripada

keputusan kajian ini, nisbah kewangan boleh meramal pulangan saham dan buku nisbah

pasaran mempunyai kuasa ramalan yang lebih tinggi daripada hasil dividen dan hasil

pendapatan masing-masing. Oleh itu, buku nisbah pasaran memainkan peranan penting

dalam menguasai variasi kukuh dalam pulangan saham. Di samping itu, nisbah

kewangan mampu untuk membangunkan pulangan saham yang diramal apabila nisbah

digabungkan dalam model regresi berganda ramal an. Untuk kajian mas a depan, adalah

disyorkan dengan menggunakan lebih daripada 10 tahun dan menambah lebih banyak

pembolehubah untuk mendapatkan data yang Iebih dipercayai dan hasil yang kuat.

v

1iI. . ..~_~---= --~--~~---~-----=-=-=-=-=-=-=-=-=-=-=--=

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ACKNOWLEDGEMENT

It is obvious that the development of a project of this scope needs the support of

many people. I'm indeed grateful to the people who helped me during all these two

semester ofhard work and dedicate this acknowledgement to all peoples who supported

directly and indirectly in prepare this final year project. First of all, I would like to thank

to God in giving me strength and spirit in completing this research. Besides that, I would

also like extend my gratitude to my parent, brother, sisters and other family members

who supported and encouraged me all the times.

Thus, I would like to express my special thanks and gratitude to my supervisor,

En. Shahal1ldin Jakpar in giving me the opportunity, advice and chances to explore

various type of financial methods which being very helpful in completing this thesis. In

addition, his support and guidance all the time has being very helpful and mainly

keeping the ship afloat in my balance. Thank you for the commitment and contribution.

I do take this opportunity to acknowledge my friends, course mates and seniors whom

have shared their experience and ideas from development of their own thesis and

provide invaluable amount of guidance for my research. Finally, I would like to thank

the faculty as well, for being kind enough to donate the resources and being helpful all

the time.

VI

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Pusat Khidnat Maklumat Akademik UNIVERSm MALAYSIA SARAWAK

TABLE OF CONTENTS

LIST OF TABLES ............................................................................. ix

LIST OF FIGURE ................................ .. ................. . ...................... ... x

CHAPTER 1: INTRODUCTION

1.0 Introduction...................... . ....................... . ..... . ....................... 1

1.1 Background of Study........ . ......................................................... 1

1.1.2 Definition of term.............................................................3

1.2 Theoretical Framework ............................................................... .4

}.3 Problems Statement ............................. .. .....................................6

1.4 Research Objectives ...................................................................7

1.5 Significance of Study.......................... . .......................................7

1.5.1 Significant of Relative Financial Ratios ...............................................8

1.6 Conclusions .............................................................................9

CHAPTER 2: LITERATURE REVIEW

2.0 Introduction...................... . ..................................................... 10

2.1 Financial Ratios and Stock Return .................................................. 10

2.1. 1 Dividend yield (DY) and Stock Return ..................................... 11

2.1. 2 Earnings yield (EY) and Stock Return .................................... 12

2.1. 3 Book-to-Market Ratio (B/M) and Stock return ......................... 13

2.2 Summary of Literature Review .... ... .................................................... 15

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1''' I

CHAPTER 3: RESEARCH METHODOLOGY

3.1 Introduction.............. .. ............................. ..... .........................24

3.2 Conceptual Fran1ework ....... ...................... . ............ ... ..................... 24

3.3 Research Design ..................................................................... 25

3.3.1 Sampling Design ............................................................. .25

3.3.2 Data Collection ..................... ..... ....................................26

3.3.3 Structures of stock return independent variable ................... .. ......27

3.4 Analysis ofData.......... . ............... ... ................ .. .. .. ............. . .....28

3.5 Fixed Effect Model ......... .. .. ... ........ .. . ... .. .. ...................................... 29

3.6 Predictive regressions ................................................................. 32

3.7 Hypothesis ........................ .. ........... ..... .............................. ....35

CHAPTER 4: FINDINGS

4.0 Introduction.. . ................. .. ................ ... .................................. 36

4.1 Empirical Result. ...... . ......................................... ................................... 36

4.1.1 Descriptive Statistic and Correlation Coefficient.. ............................ .36

4.1.2 Correlations between stock return and key variables .........................37

4.1.3 Predictive Regression ......... ... ................... .......... .................. ..... ........ 38

4.1.4 Fixed-Effects Modef ...........................................................................40

4.1.5 Multiple Regressions ..........................................................................45

4.2 Discussions ......................... .... .................................... ... .........47

4.2.1 Discussion of the Hypothesis and Findings ...............: ................... .47

Vll

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CHAPTER 5: CONCLUSION AND RECOMMENDATION

6.0 Introduction........................................................................... 51

6.] Summary................................................................................51

6.2 Conclusion .................................................................................53

6.3 Recommendation............................... . ........................................54

6.4 Limitation of Study................................... . .................................55

REFERENCES

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!

LIST OF TABLES

Table 1: List of variables...... ...... ............................. .. .........................27

Table 2: The descriptive statistics of the variables .......... .... ..........................34

Table 3: Correlations between stock return and key variables ... ....... ..... ...... .... 35

Table 4: Dividend yield predict stock returns ........................................................36

Table 5: Earning yield predict stock returns ....................... . .....................36

Table 6: Book to market ratio predict stock returns .................................... 37

Table 7: The Simple Predictive Regression Result. ............ . . . ............. ..... ...37

Table 8: White Standard Errors for LSP, DY, MBR and EY ..........................38

Table 9: Standard Errors Clustered by Time .................... . .......................39

Table 10: Standard Errors Clustered by Firm ....................................................39

Table 11: Firm Fixed Effects Model ..... ........................................................... .41

Table 12: Lagram-Multiplier test for serial correlation ....... . .... . ........................ .42

Table 13: The Multiple Predictive Regression Result. ................................... .43

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LIST OF FIGURES

Figure 1: Theoretical Framework ... ... . .... . .... .. ... . ...... . . .. ...... .... .... .. .. .... ............ . ..4

Figure 2: Conceptual Framework........ . ...... . ................ ... ............... .. ...... .. ..25

x

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CHAPTER!

INTRODUCTION

1.0 Introduction

This chapter gives an overview of the background of the study, the definition

terms, theoretical framework of study, problem statement, research objective,

significant of study, significant of Relative Financial Ratios, limitation of study and

conclusion. The main purpose of this research is to find out whether the financial

ratios such as earning yield, dividend yield and book-to- market ratios can predict the

stock return of trading and services public listed company in Malaysia.

1.1 Background of study

One of the most important sources for companies to raise money is the stock

market. This allows business to go public or raise extra capital for expansion. The

liquidity that an exchange provides allows investors the ability to sell securities

rapidly and easily. This is an attractive feature of investing in stocks compared to

other less liquid investments such as real estate. Hence, central banks tend to keep an

eye on the behaviour and control of the stock market and in general on the smooth

operation of financial system functions.

The stock return in this entry refers to the return on the portfolio of all stocks

that are traded on the equity market in the KLSE. The return is compute- as the price

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of the stock at the end of the year plus the dividends received during the year divided

by the price at the beginning of the year. A financial ratio is a relationship that

specified about a company's activities such as the ratio between company's current

liabilities and current assets or between its turnover and debtors. The ratios could

help to take those details to recognize the financial strengths and weaknesses of the

company.

Cross-sectional return predictability has been well documented for the U.S.

market and many other equity markets around the world whereby the stock returns

can be predicted by various firm characteristics such as dividend yield, market to

book ratio and earnings yield. It has been long debated for the cause of such

predictability. This study acquire a huge set of return-predictive firm characteristic

variables that are documented and examined in the U.S. market on whether these

variables can predict stock return in the Malaysia market.

According to Kendall, he states that stock prices seem to wander randomly

over time and test whether the past prices can use to predict the future price change

(Chin & }-long, 2008). After that, the studies expand to include others predictive

variables such as financial variables. However, the evidence is mixed. Even thought

there are many empirical researches on the predicting power of financial ratios on

stock return, most of the studies are focused on the developed market like United

States stock market which is similar studies on emerging market like how Malaysia

market are scanted. Kheradyar, Ibrahim & Mat Nor, (2011) pointed that the stock

return predictability contributes to achieve the maximum return with the least risk

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that will attract international investors who have a critical role in Malaysia's

economic growth. To date, academic researchers in this area are still growing in

Malaysia.

To be predictive of cross sectional stock returns at their predictability on

Malaysian stock return, this study specifically identify three firm specific variables.

The variables that have been uses are earning yield (EY), dividend yield (DY) and

book-to-market ratio (B/M).

1.1.2 Definition of term

Dividend can be defined as the allocation ofa firm's income to its shareholders.

The payments of dividends are made by a company to its shareholders. The money

can be put into two uses when a company earns a profit. It can either be paid to the

shareholders of the company as dividend or can be re-invested in the business as

retain earnings. Dividend is usually settled on a cash basis as a payment from the

company to the customer. Many companies offer a dividend reinvestment plans

which automatically use the cash dividend to purchase additional shares for the

shareholders and they can also take the form of shares in the company.

Many investment managers use the earnings yield to determine optimal asset

allocations. The earning yield shows the percentage of each dollar invested in the

stock that was earned by the company. Besides that, earning yield is not an indicator

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of the actual return on investment, it is based on the earning per shares and not the

divided received by shareholder.

Book-to-market value or known as price to book ratio is an approach of

measuring the relative value of a company contrast to its stock price or market value.

In addition, it is an essential figure to potential investors and analysts because it

gives a simple method ofjudging whether a company is over or undervalued. A good

investment opportunity means that the business has a low book to market ratio.

1.2 Theoretical Framework

Figure 1: stock return predictability with financial ratios.

Dividend Yield (DY)

Earning Yield Financial ratios Stock return (EY)

Book-to-market ratio (BIM)

(Sources: Kheradyar & Ibrahim, 2011)

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Pusat Khidmat Maklumat Akademik UNlVERSm MALAYSlA SARAWAK

The figure shown above is the theoretical framework of stock return

predictability with fmancial ratios based on three key dimensions in financial ratios.

Most of the researchers such as Kheradyar & Ibrahim (2011), Fama & French (1988),

Lewellen (2000), Chin & Hong (2008) & Kothari & Shanken (1997) applied these

three variables in financial ratios which are dividend yield, earnings yield and book

to market ratios because these variables are the most effective and useful on stock

return predictability in order to cover a wide range ofprediction.

The first key is the dividend yield which is the allocation of a firm's income to

its shareholders. Kheradyar & Ibrahim (2011) found that the predictive power of

dividend yield is greater than earnings yield. This can be supported by Fama &

French (1988), Campbell & Shiller (1988) and Cochrane (1992) that they find

dividend yield is a significant predictor of stock returns. In addition, they also find

that predictability rises as the return horizon rises. The second variable is earnings

yield which is to determine optimal asset allocations. Earning yield can reveal the

efficiency of market that has main role in emerging markets and also as the empirical

predictor of stock return. Third variable is book to market ratios. The consequences

state that security with high ratio between its book value and its market value

constantly obtains the lower return then those with low ratio. Most of the researchers

such as Kheradyar & Ibrahim (2011) use panel data and also fixed effects as well as

generalized least square model (GLS) to predict the predictive regression. They also

reported that when the ratios are combjned in the multiple predictive regressio n

models, the financial ratios are able to improve stock return predictability.

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1.3 Problems Statement

In this study, one of the problems is that stock returns are unpredictable and

difficult to forecast (Allen & Bujang, 2009). This can be support by Goyal and

Welch (2003), whereby they conclude that most variables would not be able to help

an investor in predicting historical equity premium mean. Most would have outright

hurt. None deserves an unqualified endorsement.

Based on the researches, it is found that stock return in Malaysia is weaker in

predictability. This is because it is found an intriguing contradiction of our empirical

evidence with conventional perception. It is frequently considered that return

predictability is an indication of market inefficiency. The market with higher return

predictability should be at the one with higher degree of market inefficiency in cross­

country comparisons. Furthermore, it is unlikely to explain the findings as the

Malaysia market is usually perceived to be much less efficient. This can be approved

by Hijalmarsson (2004) who found that financial ratios are not useful in predicting

the Malaysian stock return.

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1.4 Research Objectives

General Objective

The main objective of the study is to determine whether financial ratios such as

earning yield, dividend yield and book-to- market ratios can predict the stock return

of trading and services public listed company in Malaysia.

Specific Objectives

1. To determine whether earning yield can predict the stock returns in Malaysia.

2. To determine whether dividend yield can predict the stock returns in Malaysia.

3. To determine whether book-to-market ratios can predict the stock returns in

Malaysia.

4. To determine whether the combination of earning yields, dividend yield and

book-to-market ratios can predict the stock returns in Malaysia.

1.5 Significant of Study

In this study, it is important to identify that the reason of investment is to

understand a positive return over a given time period. Through this study, they will

know whether the stock returns in Malaysia can be predicted by financial ratios.

Recently, Malaysia applied some liberalizes in the stock market. It is an attractive

feature of investing in stock contrast to other less liquid investment such as real

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estate. The price of shares and other assets is a significant part of the dynamic of

economic activity and it can influence or be a gauge of social mood.

It is very important for academic alike and investors for the question of return

predictability. For academic, return predictability has large implications for general

equilibrium models that are able to explain the returns and risks in the fmancial

markets. The presence of return predictability wiU guide to a different optimal asset

allocation rules for the investors. Failing to make portfolios conditional on this

information could lead to huge welfare losses.

1.5.1 Significant of Relative Financial Ratios

That is important to compare a firm's performance relative to

• Its industry or industries

• The aggregate economy

• Its past performance (time-series analysis)

When comparing a firm's financial to industry ratios, investors may not want

to use the average or mean industry value when there is a wide variation among

firms in the industry. The comparison to the aggregate economy is significant

because almost all firms are influenced by the economic fluctuation. Hence, this

study that considers the economic environment helps investors to understand how a

firm reacts to the business cycle and whether they should improve the estimation of

the future performance of the firm during subsequent business cycles. It is possibly

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the most significant comparison which relates a firm's performance to that of its

industry. Different industries affect the firms within them differently but the

relationship is always significant. Lastly, the past performance or time series analysis

which is to examine a firm's relative performance over time is to fmd out whether it

is progressing or declining and it is helpful when estimating future performance.

1.7 Conclusion

This chapter discusses the introduction, background of the study, definition

of term used in this study, the theoretical framework from previous study, problem

statement, research objectives, significance of study and limitation of the study. This

chapter also describes the past and current issues that are related to this study. The

next chapter will discuss the previous research related to this study and the theory

which is related to the issues of informal learning spaces.

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CHAPTER 2

LITERA TURE REVIEW

2.0 Introduction

The main purpose of this chapter is to present the related literature review on

stock return predictability with financial ratios and also whether financial ratios on

the stock return can be predicted or not. The chapter starts with a brief literature on

financial ratios and stock return as well as the previous study on the predictability of

stock return. At the end of this chapter, the researcher summarizes the literature

review of the previous study.

2.1 Financial ratios and Stock return

Kheradyar, Ibrahim & Mat Nor (2011) found that financial ratios on the

predictability of stock returns literature contained a specific characteristic because

the ratios have a strong theoretical background based on the predictive models.

There are three financial theories or theoretical basis that supports these financial

ratios. First, when the stock prices are overprice, the ratios shows lower value and

predict low stock returns. This is because each ratio has stock price in the

denominator. Second, the ratios must be positively related to discount rate because

the ratios follow the time variation in discount rates. Finally, the most part of the

ratios movements which are caused by the price changes in the denominator results

in the statistical properties of the ratios to have a big crash on the test of stock return

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predictability. Therefore, the financial theoretical basis supports the three financial

ratios.

Forty years ago, Fama (1970) observed that the stock return were

unpredictable because of the overall efficiency of the markets. On the other hand,

many research studies documented the predictability of stock return based on various

predictors. Hence, the understanding of predictability is more debatable.

Stock returns are predictable in both cross-sectional and over time. Broadly

speaking, this dissertation investigates whether the empirical patterns in stock returns

are consistent with an efficient capital market. At the aggregate level, the yield

spread between low and high grade debt, aggregate dividend yield, and aggregate

book-to market predict time-variation in expected returns. Furthermore, the

researcher argue that the volatility of stock prices is too high to be explained by a

model with constant discount rates, providing indirect evidence that expected returns

change over time. At the firm level, the size and book-to-market together explain

much of the cross-sectional variation in average returns.

2.1.1 Dividend yield (DY) and Stock return

The dividends are computed as the sum of dividend paid from the companies

in the index during a given year. According to Fama & French (1988), dividend yield

has the predictive power on stock return because they find that dividend yield t­

statistic between 2.20 and 3.21 depending on the definition of returns by predicting

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the monthly NYSE returns from 1941- 1986. The article of Lewellen (2004), studies

whether financial ratios can predict aggregate stock return. He focuses on dividend

yield because it receives the most attention in the literature. To avoid the

complications arising from overlapping returns, he focuses exclusively on short­

horizon test using monthly return regressed on lagged dividend yield. The result is

dividend yield predicts both equal and value-weighted NYSE return and typically

significant at the 0.001 level with many t-statistics greater than 3.0 or 4.0.

The empirical study by Ang & Bekaert (2007) reported that dividend yield

predicts only at short horizons along with the short rate and do not have any long

horizon predictive power. The short rate strongly negative predicts returns at a short

horizon.

2.1.2 Earnings yield (EY) and Stock return

According to Graham & Dodd (1934) on the standard process of the era, the

price to earnings ratio is evaluated by stock price for more than seventy years ago.

McWilliam (1996) & Basu (1977) found that the proof of a return advantage to a low

price-to-earnings ratio and point out that stocks have special risk-return

characteristics with negative price to earnings ratios (Fama & French, 1992).

In addition, Block (1999) shows that the price-to-earnings ratio is probably still

the most well known valuation measure today which frequently cited by the media

and used by investors and analysis. Because of the price-to-earnings ratio effects on

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the value strategy of market investor, the difference in the price-to-earnings ratio are

related to the main variables such as expected earning-risk, dividend payout,

expected earnings-growth and dividend per share. The previous study by Tian &

Zheng (2008) recognized that transforming the dividend discount model to the

theoretical calculation model was the main factor that effects the price-to-earnings

ratio. Campbell & Shiller (1988) argued that for the excess stock returns in addition

to the dividend yield, the earnings yield has the independent forecasting power.

Ariff(1998), Choudhury (2003) & Hjalmarsson (2004) reported that predicting

the Malaysian stock return is not useful in financial ratios but Lau (2002) revealed

that earning price ratio was statistically significant and has positive relationship with

stock return in Malaysia.

2.1.3 Book-to-Market Ratio (BIM) and Stock return

Khan (2009) studies the effects of price per earnings ratio and market to book

ratio on stock return. The result shows that coefficient of independent variables are

statistically insignificant. This means that stock return is not depending on any of the

two independent variables. Thus, the coefficients of determination in each case are

very low which insignificant coefficients. Qouted from Fama & French (1992),

"The market to book ratio effects is even stronger than the size effect for a sample of

NYSE, AMEXand NASDAQ stocks during the period 1963-1990".

The DJIA book to market ratio was a better predictor of market returns than earlier

examined variables such as dividend yield and interest rate spreads (Pontiff & Schall,

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