  Dividend yields have been widely used in previous research to relate stock
market valuations to cash flow fundamentals. However, this approach relies on
the assumption that dividend yields are stationary. Due to the failure to
reject the hypothesis of a unit root in the classical dividend-price ratio for
the US stock market, Polimenis and Neokosmidis (2016) proposed the use of a
modified dividend price ratio (mdp) as the deviation between d and p from their
long run equilibrium, and showed that mdp provides substantially improved
forecasting results over the classical dp ratio. Here, we extend that paper by
performing multivariate regressions based on the Campbell-Shiller
approximation, by utilizing a dynamic econometric procedure to estimate the
modified dp, and by testing the modified ratios against reinvested
dividend-yields. By comparing the performance of mdp and dp in the period after
1965, we are not only able to enhance the robustness of the findings, but also
to debunk a possible false explanation that the enhanced mdp performance in
predicting future returns comes from a capacity to predict the risk-free return
component. Depending on whether one uses the recursive or population
methodology to measure the performance of mdp, the Out-of-Sample performance
gain is between 30% to 50%.
