ECONOMIC-DETERMINANTS OF THE RELATION BETWEEN EARNINGS CHANGES AND STOCK RETURNS

In competitive product markets, product prices and thus firms' revenue s incorporate the cost of equity capital. In a competitive capital mar ket, the cost of equity capital (the expected return on equity) increa ses with the risk of firms' investments. Because accounting earnings a re calculated without deducting the cost of equity capital, they are e xpected to be an increasing function of firms' investment risks. This simple competitive equilibrium analysis predicts a positive relation b etween changes in investment risk and expected earnings. The presence of corporate debt complicates the analysis because leverage effects se em likely to affect the relation between changes in investment risk an d expected earnings. Using annual earnings and return data from 1950 t o 1988, we document a statistically significant positive association b etween changes in equities' relative risks and in earnings. However, o n average, only a small proportion of changes in earnings can be attri buted to changes in risk. A much larger proportion is attributable to changes in economic rents (windfall gains and losses). The observed po sitive association between changes in earnings and changes in equities ' risks suggests that leverage effects do not fully offset the effect of changes in investment risks. This association is robust with respec t to subperiod analysis, alternative specifications of the earnings ch ange variable, alternative data-availability requirements, and the num ber of portfolios formed