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Aggregate Earnings and Stock Market Returns

| | Posted in: Fundamental Valuation

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.

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