Why does the coincident relationship between U.S. aggregate corporate earnings growth and stock market return change from negative in older research to positive in recent research? In their January 2020 paper entitled “Assessing the Structural Change in the Aggregate Earnings-Returns Relation”, Asher Curtis, Chang‐Jin Kim and Hyung Il Oh examine when the change in the aggregate earnings growth-market returns relationship occurs. They then examine factors explaining the change based on asset pricing theory (expected cash flow and expected discount rate). They calculate aggregate earnings growth as the value-weighted average of year-over-year change in firm quarterly earnings scaled by beginning-of-quarter stock price. They consider only U.S. firms with accounting years ending in March, June, September or December, and they exclude firms with stock prices less than $1 and firms in the top and bottom 0.5% of quarterly earnings growth. They calculate corresponding quarterly stock market returns from one month prior to two months after fiscal quarter ends to capture earnings announcement effects. Using quarterly earnings and returns data as specified for a broad sample of U.S. public firms from the first quarter of 1970 through the fourth quarter of 2016, they find that:
- The change in aggregate earnings growth-market return relationship occurs about the second quarter of 1991, extending through the early 1990s.
- Three factors contribute to the change:
- Cash flow (earnings) news is relatively more important than discount rate (economic variable, especially inflation) news in explaining market returns in recent data, consistent with declining volatility of economic variables.
- Discount rate news is relatively less important than cash flow news in explaining aggregate earnings growth in recent data.
- Persistence (predictability) of expected aggregate earnings growth and expected market returns decreases in recent data.
In summary, evidence suggests that decreasing volatility of economic variables is the principal reason for a change in sign from negative to positive of the relationship between aggregate U.S. firm earnings growth and stock market returns in 1991.
In other words, during the 1970s-1980s, investors worried more about economic conditions (inflation) destroying wealth than corporate performance building it; since then, corporate performance dominates economic uncertainty.
Cautions regarding findings include:
- The study addresses a coincident relationship, not a predictive one (aggregate earnings growth forecast versus future market return).
- An increased focus on, and dissemination of, aggregate earnings growth of U.S. firms may be a factor in its importance to investors.
See also “Stock Index Earnings-returns Lead-lag” and “FactSet S&P 500 Earnings Growth Estimate Evolutions”.
