Co-movement of Fundamentals: Structural Changesin the Business Cycle

The co-movement of stocks and of fundamentals changes across the business cycle. Empiricalstudies have shown that the correlation of stock returns is stronger in crisis. Weshow that the correlation of fundamentals is the highest during crisis using a large sampleof quarterly firm revenues aggregated to industry data from 1969 to 2009. Fundamentalsdrive the expectation of market participants on stock and bond prices. Structural changesin correlation of fundamentals therefore have implications on diversification decisions in equityportfolio analysis and credit risk management. The higher correlation in times of crisisincreases the downside risk and the bankruptcy probability of a portfolio. Both correlationsbetween industries and the aggregate market and correlations between earnings confirm ourfindings.