Using Accounting Earnings and Aggregate Economic Indicators to Estimate Firm-level Systematic Risk

We revisit the literature on using accounting earnings to estimate firm-level systematic risk, using macroeconomic indicators rather than listed-firm indexes to measure aggregate risk. Conventional listed-firm indexes reflect an unrepresentative subset of aggregate assets and thus are expected to substantially mis-measure aggregate and systematic risk (Roll, 1977). That choice dictates using earnings rather than returns to measure firm-level outcomes. Earnings and macroeconomic indicators both are primarily realized annual outcomes and thus are better aligned in time than forward-looking returns for capturing the contemporaneous co-movements that underlie systematic risk. Our macroeconomic indicators are chosen to reflect shocks to aggregate supply and demand, providing a parsimonious model incorporating the two fundamental determinants of aggregate risk. We find that firms' earnings-based sensitivities (betas) to aggregate supply and demand shocks are negatively correlated, and explain the cross-section of returns better than conventional "index" betas. They are correlated with firm characteristics employed in empirical asset pricing models, and explain one quarter of the explanatory power of those characteristics