Intertemporal Variation in the Information Content of Aggregate Earnings and its Effect on the Aggregate Earnings-Return Relation

Prior research documents a negative contemporaneous relation between earnings changes and stock returns at the aggregate level. We find that the aggregate earnings-returns relation turns significantly positive in recent years (1992-2013). As explanations for that shift, we test over-time shifts in the properties of firm-level earnings and the magnitude of inflation rates. To do so, we use the Bureau of Economic Analysis’ (BEA) corporate profits series as an alternative measure of aggregate earnings, because it is unaffected by changes in GAAP measurement rules and is adjusted for changes in price levels. While changes in both aggregate GAAP earnings and the BEA’s corporate profits series exhibit a significant negative (positive) relation with aggregate returns in the 1970-1991 (1992-2013) period, changes in aggregate GAAP earnings have incremental explanatory power for aggregate returns beyond the BEA’s corporate profits measure in the 1992-2013 period. Additional analysis reveals that such incremental explanatory power stems from GAAP earnings’ inclusion of non-operating items. We also find that a shift over time in inflation, as well as in the proportion of loss-making firms, contribute to inter-temporal variation in the aggregate earnings-returns relation. The effect of changes in the properties of GAAP earnings and inflation rates over time on the aggregate earnings-returns relation is new to the literature.