Long‐Term Evidence on the Effect of Aggregate Earnings on Prices

• Date: 01 June 2015
• Author: Xiaoquan Jiang,Yunhao Chen,Bong‐Soo Lee
• Published date: 01 June 2015
• DOI: http://doi.org/10.1111/fima.12063

Long-Term Evidence on the Effect

of Aggregate Earnings on Prices

Yunhao Chen, Xiaoquan Jiang, and Bong-Soo Lee∗

Weexamine the time-series properties and determinants of the relationbetween aggregate earnings

information and stock prices (aggregate earnings response coefficient or AERC) employing return

decompositions with data since 1871. Weconfirm that AERC is negative even though firms respond

positively to individual firm earnings information, but we also find that AERC is time varying.

Furthermore, we show that AERC components based on expected earnings, cash flows, and

discount rates are also time varying and differ in relative importance.

The relation between stock prices and reported earnings has attracted extensive attention in

accounting and finance research. Since Ball and Brown (1968), the literature has shown that

positive earnings changes are associated with positive stock price reactions for individual firms

(a positive earnings response coefficient or ERC). However, recent studies find that stock prices

react negatively to aggregate earnings news (a negative aggregate earnings response coefficient,

or AERC) as documented in Kothari, Lewellen, and Warner (2006), Ball, Sadka, and Sadka,

(2009), and Cready and Gurun (2010). For example, using the quarterly S&P Index from 1970 to

2000, Kothari et al. (2006) and Sadka and Sadka (2009) find that price responses are unrelated to

past aggregate earnings. Instead, they are negatively correlated with current aggregate earnings

changes. Furthermore, by using a sample of 28 countries and running time-series regressions

of market returns on aggregate earnings changes for each country, He and Hu (2013) find that

only four countries have negative coefficients for aggregate earnings changes and none of these

negative coefficients are statistically significant.

To explain the puzzling contrast between firm price reactions to f irm earnings and aggregate

earnings, we examine whether and how the AERC varies over time and what determines the

price responses to aggregate earnings changes. Furthermore, while recent studies on AERC have

furthered our understanding of the relationship between aggregate earnings and firm values, they

primarily focus on the period from the 1970s to the 2000s. In this study, we attempt to provide a

comprehensive picture of AERC over a longer period from 1871 to 2011.

Wef ind the previouslydocumented negative AERC is time-specif ic and AERC is time varying

(see Figure 1). We confirm that the time-varying property of AERC is due to two major factors.

One factor is that the stock market regulations affect the information environment of the stock

market, which, in turn, affects the investors’ perception of the value of firm disclosure. For

example, in 2000, the passage of Regulation Fair Disclosure (Reg FD) has brought more timely

and frequent communication between companies and investors thereby enhancing information

We thank two anonymous referees and Marc Lipson (Editor) for many insightful comments. Also we thank the partici-

pants at 2012 Asian Finance Association Conference in Taipei, 2012 American Accounting Association Conference in

WashingtonDC, and 2012 Financial Management Association Conference in Atlanta.

∗YunhaoChen is a visiting Assistant Professor in the Accounting Department in the School of Business Administration at

the University of Miami in Coral Gables,FL. Xiaoquan Jiang is an Associate Professor in the Department of Finance in

the College of Business at Florida International University in Miami, FL. Bong-Soo Lee is a Professorin the Department

of Finance in the College of Business at Florida State University in Tallahassee, FL.

Financial Management •Summer 2015 •pages 323 - 351

324 Financial Management rSummer 2015

Figure 1. Rolling Regressions Betas of Returns, Expected Returns, Cash Flow

News, and Discount Rate News on dE/Pwith S&P Data

This figure illustrates the betas from the 30-quarter rolling regressions of aggregate returns, expected returns,

cash flow news, and discount rate news on aggregate earnings using S&P data from 1871:Q1 to 2011:Q4.

Rm is the S&P 500 Index return, dE is the quarterly differenced earnings of the S&P 500 Index, and Pis

the market value of the S&P 500 Index. ER,Ncf,andNdr represent expected return, cash flow news, and

the discount rate news components of stock returns that are generated from VAR,respectively. The relation

between the return and its components is as described in Equation (1): rt=Et−1rt+NCFt −NDRt.

BETA_RET