Cyclicality in Aggregate Earnings and the Market Risk Premium

This study aims to examine the mechanism that governs the significant positive relationship between aggregate earnings changes and contemporaneous changes in the market risk premium. Prior studies point to this relationship but do not provide a clear explanation for it. Therefore, we divide aggregate earnings into the cycle and trend component, and explore the role of the cycle component in this relationship. Our empirical analysis yields three main results. First, aggregate earnings exhibit a cyclical pattern over time. If aggregate earnings are higher (lower) than their time trend, future earnings are expected to decrease (increase). Second, there is a significant positive relationship between the cycle component of aggregate earnings and the contemporaneous market risk premium. Investors seem to understand that a larger (smaller) cycle component of aggregate earnings conveys information on a future decline (increase) in financial performance. Third, unlike changes in the trend component, changes in the cycle component of aggregate earnings have a significant positive effect on changes in the market risk premium. This means that investors infer news on future financial performance from the cycle component of aggregate earnings, which translates into changes in the market risk premium