The Change in the Aggregate Earnings-Returns Relation and the Great Moderation

Abstract

This paper provides a comprehensive analysis of the causes of a recent structural change in the aggregate earnings-returns relation (from negative to positive). We do this by rigorously estimating the date of the structural change and then, by examining intertemporal variation in the news components, as well as those in the expected components, of both aggregate earnings and returns. We also discuss how sources of the change in the relation are related to the Great Moderation, i.e., a reduction in the economy-wide macroeconomic uncertainty that started in the mid-1980s and affected the stock market since the early 1990s. The sources that we identify include i) an increase in the relative importance of cash flow news contained in stock returns; ii) a decrease in the importance of discount rate news contained in aggregate earnings; and iii) a decrease in the persistence or the predictability of aggregate earnings and returns. Our findings suggest that reduced macroeconomic uncertainty provides a comprehensive explanation for the change in the aggregate earnings-returns relation.

Keywords: Aggregate Earnings-Returns Relation; Structural Change; Discount Rate News; Cash Flow News; Persistence; Great Moderation

JEL Classification: E31, E32, G12, G14, M41