Why Has the Contemporaneous Linear Returns-Earnings Relation Declined?

Abstract

We investigate two explanations for the declining contemporaneous linear relation between annual stock returns and accounting earnings over the past 30 years: (1) earnings increasingly reflect news with a lag relative to stock prices and (2) earnings increasingly reflect good and bad news in an asymmetric fashion. We hypothesize and find that annual earnings have a weaker association with current price changes and a stronger association with lagged price changes over time. We hypothesize and find that annual earnings reflect current positive price changes less strongly and current negative price changes more strongly over time. We also find that asymmetry with respect to lagged price changes is increasingly important over time. Strikingly, we find that, since the mid-1980s, the aggregation of earnings over a four-year window increasingly does less to reduce the importance of lags and asymmetry.