Unpacking the aggregate: what the big picture tells us about markets

Drawing on her knowledge in accounting, macroeconomics, labour economics and psychology, Assistant Professor Li Congcong of the Singapore Management University (SMU) School of Accountancy seeks to unravel this convoluted problem. By analysing market information sources and the relationships between players and variables in the economy, she derives explanations of how market expectations play out in reality.

“My current research interests are primarily in the area of the information environment – specifically, assessing the information content of accounting reports at the aggregate level and the role of information intermediaries in capital markets,” she says. “The information content of aggregate earnings also has implications for us to understand the relationship between aggregate earnings and market return, which is important for investors who hold a diversified portfolio either domestically or internationally.”

Looking at the bigger picture

Professor Li’s interest in the role of information in capital markets dates back to the time when she was a graduate student at the University of Maryland in the US. For her PhD thesis, she investigated how the media produces market information. Her current work is thus a natural extension of her earlier research inclinations, linking information to its impact on the economy.

As an independent investigator, Professor Li was intrigued by the observation that earnings are negatively related to stock returns at the aggregate level, whereas they have a positive relationship at the level of individual firms. To explain this discrepancy, Professor Li examined the information content of aggregate earnings reports in the US. She found that aggregate earnings convey monetary policy news in the form of changes to the federal funds rate – the interest rate that banks charge each other for overnight loans of reserve balances.

“In particular, the US Federal Reserve tends to adopt tight monetary policy following positive aggregate earnings, and adopt loose monetary policy following negative earnings growth,” says Professor Li. Hence, assuming positive aggregate earnings, the US Federal Reserve decides to tighten monetary policy; the federal funds rate increases, which means that banks have less cash reserves to lend, thereby dampening overall economic activity. As a result, firms’ profits decrease, and stock prices fall.

“This explains why even though many companies reported good earnings [in 2017], the stock market crashed in February 2018,” Professor Li says. She published these findings in a 2016 paper titled ‘Aggregate Earnings Surprises, Monetary Policy, and Stock Returns’ in the Journal of Accounting and Economics.

A puzzle with many pieces

The negative relationship between aggregate earnings and stock returns is not a phenomenon unique to the US, but can be observed in other geographies as well. Hence, exploiting differences in institutional and macroeconomic environments, Professor Li’s research has also shed light on variation in the aggregate earning-returns relationship across countries.

In a 2018 working paper titled ‘Is the U.S. Unique? International Evidence on the Aggregate Earnings-Returns Association,’ Professor Li and her co-authors found that the negative correlation between aggregate earnings and returns is even stronger in countries where aggregate earnings contain more monetary policy news, as well as in countries that have a stronger market reaction to monetary policy shocks.

Her research also revealed that aggregate earnings are more informative about policy changes in countries with stronger investor protection and greater macroeconomic uncertainty. This means that parameters such as government effectiveness, regulatory quality, rule of law and control of corruption are determinants of the aggregate earnings-returns association.

Furthermore, because these parameters may change over time, the aggregate earnings-returns association also fluctuates through the years. For example, prior to the year 2000, the aggregate earnings-returns association in the US was negative and statistically significant, whereas in more recent years, it was positive, albeit not always significant. The time frame of analysis is therefore important.

“This study provides new and international evidence on what drives the aggregate earnings-returns relation across the globe,” Professor Li says.

Information and the labour market

In addition to understanding aggregate earnings in the context of capital markets, Professor Li is also studying the macroeconomic information content of aggregate earnings from the labour market’s perspective.

When a company’s profitability increases, it tends to raise wages and increase its headcount. On the other hand, prolonged periods of low earnings usually lead to a hiring freeze, wage cuts or even retrenchment. By analysing the available literature on labour economics, Professor Li found empirical evidence that these trends at the individual firm level hold up at the macroeconomic scale.

Moreover, she was able to demonstrate that shocks to economy-wide profitability can be used to predict future labour market conditions. Unexpected fluctuations in aggregate core earnings, which reflect longer-term macroeconomic uncertainty, are an indicator of aggregate job creation and destruction up to four quarters ahead.

In contrast, shocks to the special items component of aggregate earnings – reflective of one-off or extraordinary events – only predict job destruction up to two quarters ahead. “Overall, I find that aggregate accounting information can predict future monetary policy news, future labour market conditions, and future GDP growth,” says Professor Li.

Back to Research@SMU Issue 60