The Dynamic Effects of Aggregate Demand and Supply Disturbances on the Aggregate Earnings-Returns Relation

Using a standard framework from Keynesian economics, we provide novel insights on the dynamic nature of the aggregate earnings-return relation. Aggregate earnings are a measure of aggregate output, and as such, they capture demand and supply shocks. Demand shocks could have positive or negative effects on returns, depending on whether they originate from shifts in monetary policy or consumer spending, whereas supply shocks are typically inflation driven, with positive effects on returns. Therefore, conditional on the driving force behind the shocks captured in aggregate earnings during a time period, aggregate earnings can be positively or negatively associated with returns. We find that, during the pre-2000 period, aggregate earnings are dominated by consumer driven demand shocks, which explains why the aggregate earnings-return relation is negative. During the post-2000 period, aggregate earnings are dominated by supply shocks, which explains the switch in the sign of the aggregate earnings-return relation from negative to positive. Using insights from our paper, we reconcile other stylized facts about the aggregate earnings-return relation in the literature. Our paper makes an important contribution to the extant literature by identifying primary economic sources of variation in aggregate earnings that drive variation in aggregate returns