Accruals and Conditional Equity Premium

Accruals correlate closely with the determinants of 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 (Hirshleifer, Hou, and Teoh [2007]). 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 (Sloan [1996]). Consistent with the risk-based explanation, aggregate accruals, as a proxy for conditional equity premium, forecast changes in aggregate economic activity. Moreover, we document a similar co-movement of earnings with 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 (Kothari, Lewellen, and Warner [2006])