Stationary Components of Earnings and Stock Prices

Abstract

I estimate a model for earnings containing a cyclical (stationary) component, in addition to a random walk trend modeled in extant studies, and investigate the extent to which the earnings cycle is capitalized in stock price. I estimate the cyclical component utilizing the Kalman filter. I find that the cyclical component of earnings is priced in addition to the trend component at a multiple of approximately one-half. I further decompose the stock price series into trend and cyclical components and find that the cyclical component of stock prices is related to that of earnings. Further tests reveal that cyclical swings in GNP and interest rates do appear to explain a portion, but not all, of the association between cyclical components of earnings and stock prices. The pricing of the cyclical component of earnings appears to capture a different phenomenon from those previously hypothesized as contributors to mean reversion in stock prices. Finally, I form hedge portfolios of firms at cyclical peaks (troughs) in earnings and report positive market adjusted returns similar to those reported in extant studies. Further tests indicate that these excess returns are not a function of firm size or betas.