Abstract
•We propose decomposition for the return predictability variation.•The large part of return predictability variation is due to its negative correlation with time-varying dividend yield autocorrelation.•The dividend yield autocorrelation is positively correlated with investor sentiment.•We show a signicantly negative relation between investor sentiment and stock return predictability.•These findings suggest that investor sentiment is an important determi-nant of time-varying short-horizon predictability.
Time-varying return predictability should stem either from time-varying dividend growth predictability or from time-varying dividend yield autocorrelation. The decomposition results show that the bulk of the variation in return predictability is due to its negative correlation with time-varying dividend yield autocorrelation, which is in turn positively correlated with investor sentiment. Using a linear regression based on these results, we confirm a significantly negative relation between investor sentiment and stock return predictability, after controlling for macroeconomic factors, dividend growth, and structural breaks. These findings suggest that investor sentiment is an important determinant of time-varying short-horizon predictability.