Market-Wide Cost of Capital Impacts on the Aggregate Earnings-Returns Relation: Evidence from Japan

Abstract

This study aims to clarify the mechanism of the surprising earnings-returns relation observed at the aggregate level by offering evidence from Japan. Unlike firm-level evidence, recent Macro-Accounting research reports that when earnings changes and stock returns of individual firms are cross-sectionally aggregated, a significantly positive relation cannot be observed in the U.S. market. To explain this puzzling finding, Kothari et al. (2006) propose a hypothesis that negative effects of changes in the market-wide cost of capital cancel out positive effects of aggregate earnings changes on aggregate stock returns. Although this hypothesis is empirically supported in the U.S market, the validity of this hypothesis has not been sufficiently investigated in the Japanese market. Thus, we test the hypothesis and find it robustly supported in Japan. Our results show that positive effects of aggregate earnings changes on aggregate stock returns are canceled out by the effects of the market-wide cost of capital. We also find that these canceling effects stem from the market risk premium in Japan. An additional test we conduct shows that expected aggregate earnings changes and changes in the market risk premium are not negatively related. This result indirectly supports the hypothesis proposed by Kothari et al. (2006), because it undermines the competing hypothesis proposed by Sadka and Sadka (2009). These results should contribute to the related research areas, Macro-Accounting and accounting research on the cost of capital.