Business Cycles and the Relation between Security Returns and Earnings

This paper examines business cycle variation in the earnings-returns relation. Earnings are more persistent when growth rates are high (i.e., in an expansion) than when growth rates are low (i.e., in a recession). Earnings are more persistent when production is high (i.e., in a credit crunch period) than when production is low (i.e., in a reliquification period). Relatedly, earnings response coefficients are larger in expansions (credit crunch periods) than in recessions (reliquification periods). Thus, earnings persistence and earnings response coefficients are positively associated with the rate of growth in economic activity and the level of economic activity. Prior research documents time series instability in earnings response coefficients (ERCs). Lev (1989, 168) points out that instability in the relation between stock returns and earnings calls into question the usefulness of earnings in explaining current returns. This paper examines whether time series instability in earnings response coefficients can be at least partially explained by “normal” fluctuations in business conditions. If variation in earnings response coefficients can be attributed to changes in the economic environment facing a firm, then our belief in the usefulness of earnings is increased and our understanding of how earnings disclosures are used by the market to assess firm value is enhanced. This research also speaks to financial statement analysis, the goal of which is the determination of the value of corporate securities by a careful examination of key value-drivers, such as earnings, risk, growth, and competitive position. This study adds to our understanding of how securities are valued by demonstrating the impact of changing business conditions on the market’s evaluation of accounting information. Similar to the conclusions drawn by Lev and Thiagarajan (1993), this study supports the importance of a contextual analysis of financial statement information. The macroeconomics literature is used to document how different stages of the business cycle—expansion, recession, credit crunch, and reliquification—reflect variation in the aggregate investing and financing opportunity set. Variation in investing and financing opportunities implies variation in how the market uses information in earnings announcements to revise expectations of future cash flows. This variation leads to predictions about intertemporal variation in earnings persistence and earnings response coefficients (ERCs) across business cycle stages. Results from a sample of 53,324 quarterly earnings announcements by Value Line firms over the period January 1970–September 1987 indicate that earnings persistence and ERCs vary across the business cycle with changes in the aggregate investment opportunity set. 94 MARILYN F. JOHNSON Earnings persistence and ERCs are lower in recessions (when investment opportunities are limited), than in expansions (when investment opportunities are high). Earnings persistence and ERCs also vary across the business cycle with changes in the aggregate financing opportunity set. Earnings persistence and ERCs are higher in credit crunch periods (when the high cost and limited availability of external financing magnify the benefits of internally generated funds) than in reliquification periods (when external financing is readily available and its cost is low). Investment opportunities are plentiful when economic growth rates are high, and financing opportunities are limited when the level of economic activity is high. Thus, these results imply that earnings persistence and earnings response coefficients are positively associated with both economic growth rates and the level of economic activity.1 The remainder of the paper is organized as follows. Characteristics of business cycles are discussed in Section 1. Hypotheses are developed in Section 2. Sample selection is described in Section 3, and the method and results are discussed in Section 4. In Section 5, a summary and conclusions are presented. 1. A Brief Introduction to Business Cycles Macroeconomics is the study of the distribution of economic activity over time. Macroeconomists typically describe the macroeconomy in terms of an irregular pattern of expansion and contraction in economic activity around a trend growth path, where fluctuations around the trend are referred to as business cycles. Figure 1 displays the stages of the typical business cycle. The remainder of this section describes how the investment and financing opportunity set varies over time as the economy moves through the business cycle from expansion, to credit crunch, to recession, to reliquification, and on to the following expansion.2 This discussion serves as the basis for the hypotheses developed in Section 2.