Understanding the Aggregate Book-to-Market Ratio

In order to connect the stock market valuation level to medium-term cash-flow fundamentals, I develop a dynamic model that links the book-to-market ratio to subsequent profitability, interest rates, and excess stock returns. My approach avoids modeling the potentially unstable dividend process. Consistent with previous research, I find that fluctuating stock market valuations are primarily driven by variation in risk premia. However, interest rate and profitability expectations also play a role in determining market prices. The model generates return and profitability forecasts. Using 1997 data, the model predicts high profitability and low, but not implausible, stock returns over the next decade.

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