Earnings, Business Cycle and Stock Returns

Abstract

We construct an earnings based zero-investment portfolio that is related to the business cycle. The portfolio, PMN, is long in stocks that have had high earnings changes in the last quarter and is short in stocks that have had low earnings changes in the last quarter. PMN is related to future macroeconomic conditions including growth in GDP, industrial production, consumption, labor income, inflation and T-bill returns and is not subsumed by the Fama-French factors. The results are consistent with the presence of a common macroeconomic factor in stock returns. Both in time-series as well as cross-sectional asset pricing tests, the momentum phenomenon is primarily attributable to PMN. Finally, we show that the post-earnings-announcement drift is related to macroeconomic conditions and that payoffs to trading strategies based on the drift may not be as profitable once macroeconomic information in stock returns is controlled for.

Keywords: Earnings momentum; Stock momentum; Post-earnings announcement drift; Macroeconomic factor; Business cycle

JEL Classification: M41, G12, G14, E32