In the absence of frictions, asset prices are discounted expected cash flows, therefore unexpected variation in asset prices is due to variation in either expected returns (discount rates) or expected future cash flows. The stock-price volatility literature generally finds that cash-flow variation is primarily idiosyncratic, diversifiable, and does not affect aggregate stock prices. Specifically, these studies find that aggregate discount rates cause most of the variation in aggregate prices (e.g., Campbell and Shiller, 1988a, 1988b; Campbell, 1991; and Campbell and Ammer, 1993).
When the analysis is applied to the cross-section of firms (e.g. Vuolteenaho, 2002; Cohen, Polk, and Vuolteenaho, 2003; Callen and Segal, 2004; and Easton, 2004), the results suggest that variation in expected profitability can explain much of the variation in firm-level returns, book-to-market ratios, and earnings-to-price ratios. These studies attribute the difference between the aggregate and firm-level results to the relative strength of the idiosyncratic components of cash-flow variation versus the systematic components of expected returns. The implication is that variation in expected returns explains most of the variation in the aggregate stock prices and aggregate stock returns.
This result is troublesome for a variety of reasons. First, it is counter-intuitive that price variation for such a large class of risky assets is independent of variation in their underlying income stream. Second, the cash-flow variable employed in these studies typically is dividends which, for multiple reasons outlined in Section 2 below, we believe is a poor proxy relative to earnings for expected cash flows.
Third, the existence of a substantial systematic component in earnings has been known since at least Brown and Ball (1967) (see also Fama and French, 1995). Fourth, an extensive accounting literature since Ball and Brown (1968) documents a positive contemporaneous correlation between idiosyncratic (firm-level) earnings and returns, a result that does not sit well with the opposite conclusion reached at the aggregate level. Fifth, accounting rules imply and the firm-level accounting literature shows that the equity market largely anticipates earnings, which suggests the need to incorporate lags in the analysis.
Aggregate Earnings and Asset Prices