Aggregate Earnings and Expected Stock Returns in Emerging Markets

Abstract

This paper examines the time-series predictability of aggregate stock returns in 20 emerging markets. In contrast to the aggregate-level findings in US, earnings yield forecasts the time-series of aggregate stock returns in emerging markets. We consider aggregate earnings not as normalizing variables for stock price but as predictive variables in their own right. Aggregate earnings themselves covary with the market returns, hence it is not just the mean reversion of stock prices that is responsible for the forecasting power of earnings yield. These results are robust across different estimation methods and after controlling for small sample bias and macroeconomic variables. We argue that due to high levels of fundamentals’ co-movement in emerging markets, the information content of firm-level earnings (unsystematic earnings) about future cash flows is not fully diversified away at the market level. Relevant literature shows that firm-level earnings are positively correlated with expected returns in US and this positive relationship remains significant only at the less diversified industry- level but disappears at the highly diversified US market level. Emerging markets are significantly less diversified compared to US. This explains the strong and robust predictive power of aggregate earnings in emerging markets.

Keywords: earnings, emerging markets, market returns, predictability, business cycle

JEL Classification: G10, G12, G14, G15