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Accruals and the Conditional Equity Premium


  • HUI GUO,

    1. Department of Finance and Real Estate, University of Cincinnati
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    1. Department of Accounting, University of Cincinnati. We thank the editor, Abbie Smith, for her encouragement. The anonymous referee deserves special thanks for providing numerous insightful and constructive comments, which greatly improve the paper. We also benefited from conversations with Mike Ferguson, Brian Hatch, Qiao Liu, Gil Sadka, Ronnie Sadka, Robert Savickas, Devin Shanthikumar, Steve Slezak, Weihong Song, and seminar participants at University of Cincinnati, the American Accounting Association 2009 FARS Meetings in New Orleans, and the 2009 FMA annual Meetings in Reno. Gil Sadka graciously provided clarifications for constructing some of the data used in this paper. We are grateful to Jay Ritter for the IPO first-day return data, to Ken French for the Fama and French three factors and portfolios sorted by size and the book-to-market equity ratio, and to Amit Goyal for stock return predictor data.
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Accruals correlate closely with the determinants of the conditional equity premium at both the firm and the aggregate levels. The common component of firm-level accruals, which cannot be diversified away by aggregation, explains the positive relation between aggregate accruals and future stock market returns. The residual component, which accounts for most variation in firm-level accruals, is responsible for the negative cross-sectional relation between firm-level accruals and future stock returns. Consistent with the risk-based explanation, aggregate accruals, as a proxy for the conditional equity premium, forecast changes in aggregate economic activity. Moreover, we document a similar comovement of earnings with the conditional equity premium at both the firm and the aggregate levels, which helps explain the negative relation between changes in aggregate earnings and contemporaneous market returns.

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