Cash conversion cycle and aggregate stock returns

Abstract

In this paper, we empirically evaluate U.S. market return predictability based on an aggregate measure constructed from the bottom-up firm-level cash conversion cycle (CCC) for 1976–2018. We show that in sharp contrast to previous firm-level evidence, the aggregate CCC is a strong positive predictor of the aggregate stock market return both in- and out-of-sample and outperforms a series of well-known return predictors documented in the literature. In addition, the aggregate CCC can predict cross-sectional stock portfolio returns sorted by size, value, momentum, firm-level CCC, and industry and generate substantial certainty equivalent gains associated with a market-timing strategy. Further analysis reveals that the economic source of the predictive power predominantly originates from misvaluation induced by investors’ biased beliefs about future aggregate cash flows, i.e., the cash-flow channel.