Cyclical Trend of Aggregate Earnings and Market Risk Premium

Abstract

This study investigates why aggregate earnings changes have a significantly positive relation with contemporaneous changes in market risk premium focusing on the cyclical trend of aggregate earnings. Prior Macro-Accounting studies only propose their empirical results and do not clarify a reason behind the relation. Since empirical results without background story are difficult to make implications, we aim to propose an explanation of the unrevealed relation. Assuming that aggregate earnings changes represent new information of the time trend deviation from aggregate earnings, we obtain three empirical results which explain the relation. First, aggregate earnings have cyclical trend. If aggregate earnings are larger (smaller) compared with their trend, future earnings will become smaller (larger). Second, such aggregate earnings predict higher (lower) future market volatility and market downside risks. Third, market volatility and market downside risks recognized from the time trend deviation of aggregate earnings are reflected on market risk premium. Our results suggest that the positive relation between aggregate earnings changes and changes in market risk premium comes from the newly recognized risk information in aggregate earnings. Our contribution is to the related Macro-Accounting research stream. First, this is the first study which reveals cyclical trend of aggregate earnings and downside risks in aggregate earnings information as long as we know. Our second contribution is providing a reasonable explanation for the positive relation between aggregate earnings changes and changes in market risk premium, whose mechanism has not been clarified before.