Do aggregate earnings guidance and actual aggregate earnings predict overall stock market returns? In his September 2006 paper entitled “Aggregate Earnings, Stock Market Returns and Macroeconomic Activity”, Lakshmanan Shivakumar discusses the relationships among aggregate earnings, stock market returns and the economy. He frames his discussion as commentary on prior research on earnings guidance, earnings news and stock returns. Using earnings, inflation and gross domestic product (GDP) data for 1972-2004, he finds and suggests that:
- Aggregate earnings change predicts only future inflation and correlates positively with future inflation. Aggregate earnings change predicts growth in nominal, but not real, GDP.
- It may be that stock market returns drive aggregate earnings guidance [which essentially measures aggregate management sentiment], rather than vice versa.
- Aggregate earnings guidance data has not been around long enough to test its correlations with other variables across multiple business cycles, and caution in interpreting such correlations is therefore warranted.
- The best methodology for structuring and assessing the surprise content of evolving guidance (forecasts) is arguable.
The following chart, taken from the paper, illustrates the author’s conceptualization of the relationships among aggregate earnings guidance (AE_guide), aggregate earnings surprises (AE_news) and future stock market returns (Rmt), as follows:
AE_guide should correlate positively with AE_news, and AE_news should correlate positively with Rmt because it indicates future aggregate cash flow.
However, AE_news potentially contains information about both future aggregate cash flow and the future discount rate. If AE_news indicates future real activity, then it would correlate negatively with discount rates and, again, positively with Rmt. On the other hand, if positive (negative) AE_news indicates higher (lower) future inflation, then it should correlate negatively with future discount rates and with Rmt.
Which of the three effects of AE_news on Rmt (cash flow effect, the discount rate effect through real activity, and the discount rate effect through inflation) dominates? Some prior research points to dominance of the third effect , with AE_news correlating negatively with Rmt.
In summary, surprisingly strong (weak) aggregate earnings news, as an indicator of high (low) future inflation, may portend relatively low (high) future stock returns.
Frequently Asked Questions
What is aggregate earnings news and how does it differ from aggregate earnings guidance?
Aggregate earnings news (AE_news) is the surprise in total corporate earnings across the market relative to expectations, while aggregate earnings guidance (AE_guide) is management's forecasts of earnings summed across firms, which essentially measures aggregate management sentiment. Shivakumar's framework expects guidance to correlate positively with earnings news.
Do aggregate earnings changes predict future inflation, GDP growth and stock market returns?
Aggregate earnings changes predict future inflation but not real GDP growth, according to Shivakumar's analysis of 1972-2004 data. Aggregate earnings change correlates positively with future inflation and predicts nominal, but not real, GDP growth. Surprisingly strong earnings news may therefore portend lower future stock returns, since it may signal higher inflation.
How does aggregate earnings news affect future stock market returns through cash flows and discount rates?
Aggregate earnings news can affect future stock market returns through three channels: a cash flow effect (positive for returns), a discount rate effect via real activity (negative for discount rates, positive for returns), and a discount rate effect via inflation (higher inflation raises discount rates, lowering returns). Shivakumar's descriptive framework, using 1972-2004 earnings, inflation and GDP data, asks which effect dominates. Some prior research suggests the inflation effect dominates, so earnings news correlates negatively with market returns.
Does strong aggregate earnings growth mean stock market returns will be higher, or does it signal lower returns?
Strong aggregate earnings news does not necessarily imply higher stock returns; it may signal lower ones. If positive earnings news indicates higher future inflation, it should correlate negatively with future discount rates and market returns, which outweighs the cash flow effect in some prior research. Surprisingly strong (weak) aggregate earnings news may thus portend relatively low (high) future stock returns.
What are the limitations of using aggregate earnings guidance to predict stock market returns?
Aggregate earnings guidance data has not existed long enough to test its correlations with other variables across multiple business cycles, so caution in interpreting results is warranted. The best methodology for structuring and assessing the surprise content of evolving guidance is also arguable. Causality may run the other way, with stock market returns driving aggregate earnings guidance rather than vice versa.