Aggregate Earnings News and Stock Market Returns: The Good, the Bad and the State-Dependent

Abstract

In this study we examine the stock market’s reaction to aggregate earnings news. Prior research shows that, in contrast to individual-firm earnings, a) stock markets’ response to aggregate earnings surprise is negative, consistent with aggregate earnings news being predominantly informative about discount-rate rather than cash-flows and b) stock market returns are unrelated to past earnings, thus, finding no evidence of the post-earnings announcement drift. We show that the information content of aggregate earnings news is state-dependent. Using Markov switching mixture of distributions framework we find that the effect of aggregate earnings news on stock market can be either positive or negative, depending on the state of the economy. In one state aggregate earnings surprise is positively related to the innovations in discount-rate, while in other it is positively (inversely) related to the cash-flow (discount-rate) news. After controlling for the state of the economy we do find evidence of the post-earnings announcement drift. The probability of economy being in the “pure” discount-rate state is higher following positive shocks to the term-spread and aggregate money supply, as well as during the periods of high interest rates and high market P/E multiples. Finally, we document significant cross-sectional variation in the response of size and book-to market sorted portfolios to the aggregate earnings news in both economic states. Overall, our results suggest that to understand the stock market’s reaction to aggregate earnings news one must take into account its state-dependent nature.