Economic Determinants of Intertemporal Variation in the Aggregate Earnings-Returns Relation: The Role of Inflation, Risk Premium and Real Output News Components of Aggregate Earnings
54 Pages Posted: 12 Mar 2016 Last revised: 11 Dec 2018
Date Written: December 10, 2018
Using a lengthy time-series of data encompassing diverse economic conditions, different monetary policy regimes, as well as changes in the composition of firms making up the U.S. economy, we provide evidence on the drivers of intertemporal variation in the aggregate earnings-aggregate returns (AE–AR) relation by first documenting how AE’s inflation, risk premium, and real output (i.e., cash flow) news components vary over time. We find that AE growth predominantly reflects inflation news in the 1970s and 1980s, real output (i.e., cash flow) news in the 1990s and 2000s, and a relatively time-invariant inverse relation with news about the risk premium. This evidence provides a natural explanation that the previously documented negative (positive) AE–AR relation in the 1970s and 1980s (1990s and 2000s) is driven by a dominant inflation (real output) news component in AE growth. Additional analysis indicates that AE growth’s real output news component becomes more prominent in the 1990s and 2000s relative to the 1970s and 1980s in part due to the shift in the composition of firms in the U.S. economy toward financial firms, whose sectoral earnings function as a leading indicator for economy-wide real output growth.
Keywords: aggregate earnings-returns relation; aggregate earnings; market returns; discount rate news; inflation news; cash flow news; industrial production growth; expected returns; Bureau of Economic Analysis; inventory valuation adjustment; financial sector
JEL Classification: E30, G10, M41
Suggested Citation: Suggested Citation