Market Return Decomposition and Equity Risk Premium Predictability

We introduce a novel decomposition of stock market returns into a fundamental component (FC), capturing long-term growth, and an unexpected capital gain component (UC), reflecting short-term fluctuations. The decomposition is explicit, straightforward to estimate, and designed to correct model misspecification in traditional predictive regressions. The FC aligns with highly persistent valuation ratios, while the UC is predictable via standard regressions, further improved by shrinkage. Using 41 predictors from Goyal et al. (2024), we find 33 significant predictors of market returns, compared with only 5 in their study. We argue that predictors jointly contain valuable information about stock returns, with combination forecasts showing significant out-of-sample predictive power, reaffirming the predictability of the equity risk premium documented in prior research.