Time Variation in Cash Flows and Discount Rates

We analyze the decomposition of the conditional, rather than the unconditional, variance of market returns based on an extension of the standard Campbell-Shiller approach. The relative importance of cash flow and discount rate news in determining the conditional variance of market returns exhibits significant variation over time and relates to economic conditions. The components of the conditional market variance outperform several benchmark variables, including the conditional market variance itself, in forecasting future market returns and realized variance across different horizons. The forecasts based on the conditional market variance components also provide sizable economic benefits compared with benchmark forecasts in an out-of-sample portfolio exercise where a myopic investor allocates her wealth between the market portfolio and a risk-free asset across different holding periods.