Intertemporal variation in the information content of aggregate earnings and its effect on the aggregate earnings-return
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Intertemporal variation in the information content of aggregate earnings and its effect on the aggregate earnings-return relation Jaewoo Kim 1 & Bryce Schonberger 2,4 & Charles Wasley 2 & Hunter Land 3 # Springer Science+Business Media, LLC, part of Springer Nature 2020
Abstract We develop and test explanations for sources of intertemporal variation in the information content of aggregate earnings and how that variation explains variation in the relation between aggregate earnings growth and market returns over time. We find that the correlation between aggregate earnings growth and leading market-wide real output shocks (measured by the growth in the Federal Reserve Board’s index of industrial production) becomes more pronounced in the 1990s and 2000s, which explains why the aggregate earnings-return relation is significantly positive in this period. Further analysis shows that an increasingly positive relation between aggregate earnings growth and real output shocks is attributable to the changing nature of the economic activity in the United States, namely, a shift in the composition of firms toward financial services and away from manufacturing. Changes in accounting measurement rules over time to include more fair value estimates also play a role in explaining why the aggregate earnings–return relation has become significantly positive in recent decades. Keywords Aggregate earnings . Aggregate earnings-return relation . Market returns . Real
output . Industrial production growth . Financial sector . Fair value accounting JEL classification E30 . G10 . M41
* Bryce Schonberger [email protected] Jaewoo Kim [email protected] Charles Wasley [email protected] Hunter Land [email protected] Extended author information available on the last page of the article
J. Kim et al.
1 Introduction Ball and Sadka (2015) state that research on the relation between aggregate earnings growth and equity market returns (hereafter, AE-AR relation) is important to diversified investors, policymakers, and economists seeking to understand the information contained in market-wide earnings with regard to real economic performance. Consistent with this importance, research has focused on explanations for the sign of the contemporaneous AE–AR relation (e.g., Kothari et al. 2006; Sadka and Sadka 2009; Gallo et al. 2016; Choi et al. 2016; Shivakumar and Urcan 2017) and on variation in the AE-AR relation over time. Studies in this latter group find that the sign of the AE-AR relation shifts from negative in pre-1990 periods to positive in the 1990s and 2000s (e.g., Sadka and Sadka 2009; Zolotoy et al. 2017). A key feature of research on the AE-AR relation is the assumption that the information content (and resulting properties) of aggregate earnings is stable. This feature of prior research motivates us to develop and test explanations for intertemporal variation in the information content of AE growth and how that variation explains the AE-AR relation over time. Simply put, our study investigates w
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