Abstract
We adopt a heterogeneous regime switching method to examine the informativeness of accounting earnings for stock returns. We identify two distinct time-series regimes in terms of the relation between earnings and returns. In the low volatility regime (typical of bull markets), earnings are moderately informative for stock returns. But in high volatility market conditions (typical of financial crisis), earnings are strongly related to returns. Our evidence suggests that earnings are more informative to investors when uncertainty and risk is high which is consistent with the idea that during market downturns investors rely more on fundamental information about the firm. Next, we identify groups of firms that follow similar regime dynamics. We find that the importance of accounting earnings for returns in each of the market regimes varies across firms: certain firms spend more time in a regime where their earnings are highly relevant to returns, and other firms spend more time in a regime where earnings are moderately relevant to returns. We also show that firms with poorer accrual quality have a greater probability of belonging to the high volatility regime.
Highlights
Accounting and finance have a long tradition of studying the relation between accounting earnings and stock market returns
The degree to which accounting earnings provides useful information for stock markets is of considerable interest to businesses, investors and regulators
A number of academic studies document a decline in the usefulness of earnings for returns and suggest that increased return volatility and deterioration in the quality of the accounting system explain the decline
Summary
Accounting and finance have a long tradition of studying the relation between accounting earnings and stock market returns. We establish an association between firms’ fundamental characteristics such as accrual quality, and the time and cross-sectional variation in the usefulness of earnings for returns. In a similar vein Ryan and Zarowin (2003) report that the time series decline in the in the usefulness of earnings is explained by changes the accrual component of earnings They conclude that the decline is attributable to the quality of accounting not to the change in the economic conditions of the firms. Firms might experience some periods when earnings are more correlated with returns and others when they are less Further this cross-sectional variation in the usefulness is likely to be associated with firm-specific conditions which are reflected in earnings and other accounting variables. The heterogeneous regime switching methodology provides support for the identification of earnings-returns regimes breaks and identify groups of firms with similar regime dynamics
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