Earnings Dispersion and Aggregate Stock Returns

Abstract

While aggregate earnings should affect aggregate stock returns, standard portfolio theory predicts that the cross-sectional dispersion in firm-level earnings would not affect aggregate stock returns. Nonetheless, this paper demonstrates a surprisingly robust relation between cross-sectional earnings dispersion and aggregate stock returns. Particularly, we document that cross-sectional earnings dispersion is positively (negatively) correlated with contemporaneous (lagged) stock returns. We offer two alternative interpretations for our results. First, higher earnings dispersion results in short-run unemployment shocks, as workers migrate to better performing firms, suggesting that investors demand higher rates of returns when expected unemployment rises. Second, higher technological uncertainty leads to higher expected dispersion in earnings changes which results in more uncertainty about aggregate earnings changes and less predictability. Consequently, investors demand higher expected rates of return during periods of higher uncertainty about future earnings.