# Tag Archives: dividend growth

In this post I will attempt to replicate some basic results from Cochrane’s(2008) paper ,-‘The Dog that did not bark : a defense of return predictability’ – ; as usual with the posts found on this blog,I do not claim to understand many of the nuances of the paper or the mathematics/statistical procedures behind it (in fact most of it is completely beyond me), it is nevertheless interesting to see how much one can tinker with and replicate using online resources for free.

The present value identity sketched in previous posts establishes the following relationship between [1] dividend yield ,[2] dividend growth and [3] return variables. If the state of the world were such that observed dividend yields are constant over time,then neither return nor dividend growth variables are predictable. Since the state of the world is such that observed dividend yields vary over time,it must be the case that at least one of dividend growth or return is/are predictable. Simple regressions that were run in previous posts establish several main findings (which i shall repeat lest i forget them again) :

1. The dividend price ratio predicts returns but NOT dividend growth.
2. Long-horizon return regressions provide stronger evidence of return predictability than single period counterparts.
3. Returns which should not be forecastable are and dividend growth which should be forecastable isn’t.
4. On average,price dividend ratios are moving in response to expected return news rather than cash flow news.
5. Time varying discount rates explain virtually all the variance of dividend yield while dividend growth forecasts explain essentially none of it.

As has been repeated quite often in these posts on time series predictability: If returns are not predictable, dividend growth must be predictable, to generate the observed variation in dividend yields.The most basic (but nonetheless important) result of Cochrane’s paper that we are going to replicate is the finding that [1] the absence of dividend growth predictability gives stronger evidence than does the presence of return predictability and that [2] long-horizon return forecasts complement single period results. There will be some discrepancies between Cochrane and our results which are probably due to [1] coding errors on my part, [2] not using real (inflation adjusted) variables since they are a hassle to find online (…at least to me), and [3] the use of 20000 monte carlo trials instead of the 50000 used in the paper. Also,I wrote the code almost a year ago and have only come around to blogging about it now,hence many of the issues that may have cropped up at that time are oblivious to me at the moment. This part of the post simply outlines some of the intuitions and procedures behind Cochrane’s paper, as well as the dataset and custom functions used in the code. The subsequent post shall deal with the results obtained and perhaps compare them somewhat to those of the paper.

[Data]

The data used in the code comes from the Chicago Booth advanced investments seminar, which contains [1]Return, [2]Dividend-yield,[3] Dividend-growth and [4] T-bill rate variables. The data file I have goes from 1926 to 2011,the one from the linked site goes to 2012. We only need data from 1927 to 2004, so it doesn’t really matter.After converting the txt file to a csv file in Excel,let’s load it into R,transform some of the variables to the ones we need and subset the data to the date range used in the paper.
ll

```#####################################################################################
# Load and extract annual data
#####################################################################################

#Import csv file
orig.ts &lt;- ts(data=orig.csv,start=c(1926),end=c(2011),frequency=1)
orig.extract &lt;- window(orig.ts,start=c(1926),end=c(2004),frequency=1)
orig.extract &lt;- cbind(orig.extract,orig.extract[,1]-orig.extract[,4],log(1+orig.extract[,1]),log(orig.extract[,2]),log(1+orig.extract[,3]))
colnames(orig.extract) &lt;- c('Idx.ret','Div.yield','Div.growth','Tbill.ret','Exc.ret','log.ret','log.div.yield','log.div.growth')
```

kkk

[Functions]

Functions include: SimulateVAR(),MonteCarloSimulation(),JointPlot(),RegExtractor(),TableMaker(),of which the last two are general helper functions to extract results from regression objects and display tabular information from matrices and such respectively. I don’t know why the code,when copied into wordpress,becomes oddly misaligned at times.
ll

```#####################################################################################
#Extract Regression Values
#####################################################################################
RegExtractor &lt;- function(x,type)
{
if(type=='est'){
output &lt;- t(sapply(x,function(v)coef(summary(v))[,1]))
}
else if (type=='stderr'){
output &lt;- t(sapply(x,function(v)coef(summary(v))[,2]))
}
else if(type=='tval'){
output &lt;- t(sapply(x,function(v)coef(summary(v))[,3]))
}
else if(type=='pval'){
output &lt;- t(sapply(x,function(v)coef(summary(v))[,4]))
}
else if(type=='rsq'){
output &lt;- t(sapply(x,function(v)(summary(v))\$r.squared))
}
else if(type=='res'){
output &lt;- sapply(x,function(v)(resid(v)))
}
return(output)
}
#####################################################################################

#####################################################################################
# Simulate the VAR
#####################################################################################

SimulateVAR &lt;- function(num.obs,phi,rho,error.cov){
dp.sd = round(sqrt(var(error.cov))[2,2],3)
dg.sd = round(sqrt(var(error.cov))[1,1],2)
dp.shock = rnorm(num.obs+1,mean=0,sd=dp.sd)
dg.shock = rnorm(num.obs,mean=0,sd=dg.sd)
sim.data = matrix(data=0,nrow=num.obs,ncol=3,dimnames=list(NULL,c('sim.divyield','sim.dgrowth','sim.returns')))

ifelse(phi&lt;1,dp.beg&lt;-rnorm(1,mean=0,sd=dp.sd^2/(1-phi^2)),dp.beg&lt;-0)

sim.data[1,'sim.divyield'] &lt;- phi*dp.beg+dp.shock[2]
sim.data[1,'sim.dgrowth'] &lt;- ((rho*phi)-1)*dp.beg+dg.shock[1]

for(i in 2:num.obs){
sim.data[i,'sim.divyield']&lt;- phi*sim.data[(i-1),'sim.divyield']+dp.shock[i+1]
sim.data[i,'sim.dgrowth'] &lt;- ((rho*phi)-1)*sim.data[(i-1),'sim.divyield']+dg.shock[i]
}
sim.data[,'sim.returns'] &lt;- dg.shock-(rho*dp.shock[2:(num.obs+1)])
return(data.frame(sim.data))
}
#####################################################################################

#####################################################################################
# MonteCarlo
#####################################################################################

MonteCarloSimulation &lt;-function(num.trials,num.obs,phi,rho,error.cov){
coeff.names &lt;- c('b[r]','b[d]','phi')
montecarlo.results &lt;- matrix(data=0,nrow=num.trials,ncol=8,dimnames=list(NULL,c(coeff.names,paste(coeff.names,'_tstat',sep=''),c('b[long.r]','b[long.d]'))))
inputs &lt;- c(num.trials=num.trials,num.obs=num.obs,phi=phi,rho=rho,error.cov=error.cov)

for(i in 1:num.trials){
simulated.data &lt;- SimulateVAR(num.obs,phi,rho,error.cov)
sim.reg &lt;- list(
dyn\$lm(sim.returns~lag(sim.divyield,-1),data=ts(simulated.data)),
dyn\$lm(sim.dgrowth~lag(sim.divyield,-1),data=ts(simulated.data)),
dyn\$lm(sim.divyield~lag(sim.divyield,-1),data=ts(simulated.data))
)
montecarlo.results[i,1:3] &lt;- (RegExtractor(sim.reg,'est')[,2])
montecarlo.results[i,4:6] &lt;- (RegExtractor(sim.reg,'tval')[,2])
montecarlo.results[i,7] &lt;- montecarlo.results[i,1]/(1-rho*montecarlo.results[i,3])
montecarlo.results[i,8] &lt;- montecarlo.results[i,7]-1

print(paste('Monte Carlo Simulation :',i))
}
return(list(inputs,montecarlo.results))
}
#####################################################################################

######################################################################################
# Joint distribution plot
######################################################################################

JointPlot &lt;- function(mc.object,num.points,initial.reg,type){

#Define variables
betas &lt;- matrix(RegExtractor(initial.reg,'est')[,2],ncol=1)
tvals &lt;- matrix(RegExtractor(initial.reg,'tval')[,2],ncol=1)
num.trials &lt;- mc.object[[1]]['num.trials']
rho &lt;- mc.object[[1]]['rho']
phi &lt;- betas[6]
lr.beta &lt;- betas[4]/(1-rho*phi)

if(type=='single period'){

bottom.right &lt;- length(mc.object[[2]][which(mc.object[[2]][,'b[r]']&gt;betas[4] &amp; mc.object[[2]][,'b[d]']&lt;betas[5],)])/num.trials*100
top.right &lt;- length(mc.object[[2]][which(mc.object[[2]][,'b[r]']&gt;betas[4] &amp; mc.object[[2]][,'b[d]']&gt;betas[5],)])/num.trials*100
bottom.left &lt;- length(mc.object[[2]][which(mc.object[[2]][,'b[r]']&lt;betas[4] &amp; mc.object[[2]][,'b[d]']&lt;betas[5],)])/num.trials*100
top.left &lt;- length(mc.object[[2]][which(mc.object[[2]][,'b[r]']&lt;betas[4] &amp; mc.object[[2]][,'b[d]']&gt;betas[5],)])/num.trials*100

plot(ylim=c(min(mc.object[[2]][1:num.points,'b[d]'])-0.15,max(mc.object[[2]][1:num.points,'b[d]'])+0.15),xlim=c(min(mc.object[[2]][1:num.points,'b[r]'])-0.15,max(mc.object[[2]][1:num.points,'b[r]'])+0.15),x=mc.object[[2]][1:num.points,'b[r]'],y=mc.object[[2]][1:num.points,'b[d]'],ylab='b[d]',xlab='b[r]',cex.main=0.85,cex.lab=0.75,cex.axis=0.75,cex=0.65,main=paste('Coefficients\nphi=',mc.object[[1]]['phi']),col='blue',pch=21)
abline(h=betas[5])
abline(v=betas[4])
points(x=betas[4],y=betas[5],col='red',cex=1,pch=19)
points(x=0,y=mc.object[[1]]['rho']*mc.object[[1]]['phi']-1+0,cex=1,pch=17,col='green')

text(x=max(mc.object[[2]][1:num.points,'b[r]']),y=min(mc.object[[2]][1:num.points,'b[d]'])-0.1,paste(bottom.right,'%'),cex=0.75)
text(x=max(mc.object[[2]][1:num.points,'b[r]']),y=max(mc.object[[2]][1:num.points,'b[d]'])+0.1,paste(top.right,'%'),cex=0.75)
text(x=min(mc.object[[2]][1:num.points,'b[r]']),y=min(mc.object[[2]][1:num.points,'b[d]'])-0.1,paste(bottom.left,'%'),cex=0.75)
text(x=min(mc.object[[2]][1:num.points,'b[r]']),y=max(mc.object[[2]][1:num.points,'b[d]'])+0.1,paste(top.left,'%'),cex=0.75)

bottom.right &lt;- length(mc.object[[2]][which(mc.object[[2]][,'b[r]_tstat']&gt;tvals[4] &amp; mc.object[[2]][,'b[d]_tstat']&lt;tvals[5],)])/num.trials*100
top.right &lt;- length(mc.object[[2]][which(mc.object[[2]][,'b[r]_tstat']&gt;tvals[4] &amp; mc.object[[2]][,'b[d]_tstat']&gt;tvals[5],)])/num.trials*100
bottom.left &lt;- length(mc.object[[2]][which(mc.object[[2]][,'b[r]_tstat']&lt;tvals[4] &amp; mc.object[[2]][,'b[d]_tstat']&lt;tvals[5],)])/num.trials*100
top.left &lt;- length(mc.object[[2]][which(mc.object[[2]][,'b[r]_tstat']&lt;tvals[4] &amp; mc.object[[2]][,'b[d]_tstat']&gt;tvals[5],)])/num.trials*100

plot(ylim=c(min(mc.object[[2]][1:num.points,'b[d]_tstat'])-1,max(mc.object[[2]][1:num.points,'b[d]_tstat'])+1),xlim=c(min(mc.object[[2]][1:num.points,'b[r]_tstat'])-1,max(mc.object[[2]][1:num.points,'b[r]_tstat'])+1),x=mc.object[[2]][1:num.points,'b[r]_tstat'],y=mc.object[[2]][1:num.points,'b[d]_tstat'],ylab='tstat,b[d]',xlab='tstat,b[r]',cex.main=0.85,cex.lab=0.75,cex.axis=0.75,cex=0.65,main=paste('T-statistics\nphi=',mc.object[[1]]['phi']),col='blue',pch=21)
abline(h=tvals[5])
abline(v=tvals[4])
points(x=tvals[4],y=tvals[5],col='red',cex=1,pch=19)

text(x=max(mc.object[[2]][1:num.points,'b[r]_tstat']),y=min(mc.object[[2]][1:num.points,'b[d]_tstat'])-0.1,paste(bottom.right,'%'),cex=0.75)
text(x=max(mc.object[[2]][1:num.points,'b[r]_tstat']),y=max(mc.object[[2]][1:num.points,'b[d]_tstat'])+0.1,paste(top.right,'%'),cex=0.75)
text(x=min(mc.object[[2]][1:num.points,'b[r]_tstat']),y=min(mc.object[[2]][1:num.points,'b[d]_tstat'])-0.1,paste(bottom.left,'%'),cex=0.75)
text(x=min(mc.object[[2]][1:num.points,'b[r]_tstat']),y=max(mc.object[[2]][1:num.points,'b[d]_tstat'])+0.1,paste(top.left,'%'),cex=0.75)

} else if(type=='long horizon'){

h&lt;-hist(plot=FALSE,mc.object[[2]][,'b[long.r]'],breaks=100)
plot(xlim=c(-3,3),h,freq=FALSE,col=ifelse(h\$breaks&lt;=lr.beta,'lightgrey','red'),ylab='',xlab='b(r)/(1-rho*phi)',cex.main=0.85,cex.lab=0.75,cex.axis=0.75,cex=0.65,main=paste('phi=',mc.object[[1]]['phi']))
abline(v=lr.beta,col='red')
text(x=lr.beta+0.3,y=0.45,'Data',col='black',cex=0.75)

bottom.right &lt;- length(mc.object[[2]][which(mc.object[[2]][,'b[r]']&gt;betas[4] &amp; mc.object[[2]][,'phi']&lt;phi,)])/num.trials*100
top.right &lt;- length(mc.object[[2]][which(mc.object[[2]][,'b[r]']&gt;betas[4] &amp; mc.object[[2]][,'phi']&gt;phi,)])/num.trials*100
bottom.left &lt;- length(mc.object[[2]][which(mc.object[[2]][,'b[r]']&lt;betas[4] &amp; mc.object[[2]][,'phi']&lt;phi,)])/num.trials*100
top.left &lt;- length(mc.object[[2]][which(mc.object[[2]][,'b[r]']&lt;betas[4] &amp; mc.object[[2]][,'phi']&gt;phi,)])/num.trials*100

plot(ylim=c(min(mc.object[[2]][1:num.points,'phi'])-0.1,max(mc.object[[2]][1:num.points,'phi'])+0.1),xlim=c(min(mc.object[[2]][1:num.points,'b[r]'])-0.1,max(mc.object[[2]][1:num.points,'b[r]'])+0.1),x=mc.object[[2]][1:num.points,'b[r]'],y=mc.object[[2]][1:num.points,'phi'],ylab='phi',xlab='b[r]',cex.main=0.85,cex.lab=0.75,cex.axis=0.75,cex=0.65,main=paste('phi=',mc.object[[1]]['phi']),col='blue',pch=21)
abline(h=phi)
abline(v=betas[4])
points(x=betas[4],y=phi,col='red',cex=1,pch=19)
points(x=0,y=mc.object[[1]]['phi'],cex=1,pch=17,col='green')
lines(x=1-rho*mc.object[[2]][,'phi']+betas[5],y=mc.object[[2]][,'phi'],lty='dotted',lwd=0.75,col='gold')
lines(x=betas[4]*(1-rho*mc.object[[2]][,'phi'])/(1-phi*rho),col='black',y=mc.object[[2]][,'phi'],lwd=0.75)

text(x=max(mc.object[[2]][1:num.points,'b[r]']),y=min(mc.object[[2]][1:num.points,'phi'])-0.06,paste(bottom.right,'%'),cex=0.75)
text(x=max(mc.object[[2]][1:num.points,'b[r]']),y=max(mc.object[[2]][1:num.points,'phi'])+0.06,paste(top.right,'%'),cex=0.75)
text(x=min(mc.object[[2]][1:num.points,'b[r]']),y=min(mc.object[[2]][1:num.points,'phi'])-0.06,paste(bottom.left,'%'),cex=0.75)
text(x=min(mc.object[[2]][1:num.points,'b[r]']),y=max(mc.object[[2]][1:num.points,'phi'])+0.06,paste(top.left,'%'),cex=0.75)

}
}

################################################################################
#Table Maker
################################################################################

{
rows &lt;- nrow(core)+1
cols &lt;- ncol(core)
idx &lt;- 1

plot.new()
plot.window(xlim=c(0,cols*11),ylim=c(0,rows*7))
mtext(title,side=3,cex=0.7)

for(i in 1:cols){
for(j in 1:rows){
if(j==1){
}
else if((j&gt;1) &amp;&amp; (row.h==0))
{
rect((i-1)*11,(j-1)*7-7,11*i,(j-1)*7,density=NA,col=ifelse(strip,ifelse(core[j-1,i]&lt;col.cut,colours[1],colours[2]),'white'),lwd=1.0,border=border.col)
text(((i-1)*11+11*i)/2,(((j-1)*7-7)+(j-1)*7)/2,core[j-1,i],col='black',cex=0.75,font=1)
}
else if((j&gt;1) &amp;&amp; (row.h!=0) &amp;&amp; (i==row.h[idx]))
{
rect((i-1)*11,(j-1)*7-7,11*i,(j-1)*7,density=NA,col=border.col,lwd=1.0,border=border.col)
text(((i-1)*11+11*i)/2,(((j-1)*7-7)+(j-1)*7)/2,core[j-1,i],col='black',cex=0.75,font=1)
}
else if((j&gt;1) &amp;&amp; (row.h!=0) &amp;&amp; (i!=row.h[idx]))
{
rect((i-1)*11,(j-1)*7-7,11*i,(j-1)*7,density=NA,col=ifelse(strip,ifelse(core[j-1,i]&lt;col.cut,colours[1],colours[2]),'white'),lwd=1.0,border=border.col)
text(((i-1)*11+11*i)/2,(((j-1)*7-7)+(j-1)*7)/2,core[j-1,i],col='black',cex=0.75,font=1)
}
}
ifelse(idx&lt;length(row.h),idx&lt;-idx+1,idx&lt;-length(row.h))

}
}
#####################################################################################
#####################################################################################
#@@@@@@@@@@@@@@@@@@@@@@@@@@@Function Ends@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@#
```

ll

[Intuition & Procedure]

Cochrane starts with the conventional VAR representation that links log returns,dividend yield and dividend growth variables as seen before:

The Campbell-Shiller (1988) linearisation of returns is then used to link regression coefficients and errors of the VAR such that one can infer the data,coefficients and errors for any one equation from those of the other two :

We are interested in learning something about the return predictability coefficient b(r) on the basis of what we can say about phi. In this framework,to generate a coherent null hypothesis with b(r)=0,one must assume a negative b(d) and then address the absence of this coefficient in the data. Essentially this hypothesis will be tested by simulating the VAR under the assumption of no return predictability,b(r)=0 and dividend growth predictability,b(d)=negative. The simulation procedure is as follows (taken from the original paper and other sites such as this presentation) :

[1] Obtain original sample estimates (1927-2004) and the error covariance matrix by running the three VAR regressions. This step provides the inputs needed for the subsequent simulation.

[2] Each of the 20000 monte carlo trials (50000 in the paper) generates a dataset simulated according to the following (shamelessly snipped from the presentation) :

[3] Once we have 20000 simulated datasets,we run each of the VAR regressions for each simulated dataset and collect regression estimates.

[4] Once we have collected regression results across 20000 simulated datasets,we can look at the probability of observing b(r) and b(d) pairs as well as t-statistic pairs that are more extreme than original sample estimates.

[5] Once we have looked at the single period results,we can proceed with the long-horizon regression coefficients ( which are mercifully not new estimates, but rather calculated from the single period estimates of the original sample 1927-2004)

[6] Once we have summarised both single-period and long horizon results ,we can look at the source of power regarding single-period dividend growth coefficients and long horizon tests, as well as examine the effect of varying dividend yield autocorrelation on short- and long run percentage values.