Capital Investment, Earnings, and Annual Stock Returns: Causality Relationships in China

Abstract

The Granger-causality effects between earnings, cash flow, and capital investment as well as on subsequent annual stock returns are examined for China in an international framework. Overall, there is a Granger causality relationship from earnings to capital investment. Furthermore, there is strong causality in the reverse direction as well. Capital investment causes positive subsequent stock returns while earnings have a more direct and contemporaneous impact on stock prices. Regulatory mechanisms, managerial monitoring, state capitalism controls work best during expansions and non-crisis periods. The causality relationships diminish during recessions and crisis periods, such as the Asian Crisis. The results observed in China are different from the results for G7 countries, or the results for other non-G7 countries. Using cash flows instead of earnings confirms the conclusions. Insider ownership is not necessarily as effective as other control mechanisms in China.

Keywords: Earnings, Capital Investment, Annual Stock Returns

JEL Classification: G30, G31, G34