Review of Accounting Studies, 4, 93–117 (1999)
1999 Kluwer Academic Publishers, Boston. Manufactured in The Netherlands.
Business Cycles and the Relation between Security
Returns and Earnings
MARILYN F. JOHNSON
University of Michigan Business School, 701 Tappan Street, Ann Arbor, MI 48109-1234
Abstract. This paper examines business cycle variation in the earnings-returns relation. Earnings are more
persistent when growth rates are high (i.e., in an expansion) than when growth rates are low (i.e., in a recession).
Earnings are more persistent when production is high (i.e., in a credit crunch period) than when production is low
(i.e., in a reliquiﬁcation period). Relatedly, earnings response coefﬁcients are larger in expansions (credit crunch
periods) than in recessions (reliquiﬁcation periods). Thus, earnings persistence and earnings response coefﬁcients
are positively associated with the rate of growth in economic activity and the level of economic activity.
Prior research documents time series instability in earnings response coefﬁcients (ERCs).
Lev (1989, 168) points out that instability in the relation between stock returns and earn-
ings calls into question the usefulness of earnings in explaining current returns. This
paper examines whether time series instability in earnings response coefﬁcients can be
at least partially explained by “normal” ﬂuctuations in business conditions. If variation
in earnings response coefﬁcients can be attributed to changes in the economic environ-
ment facing a ﬁrm, then our belief in the usefulness of earnings is increased and our
understanding of how earnings disclosures are used by the market to assess ﬁrm value is
This research also speaks to ﬁnancial statement analysis, the goal of which is the deter-
mination of the value of corporate securities by a careful examination of key value-drivers,
such as earnings, risk, growth, and competitive position. This study adds to our under-
standing of how securities are valued by demonstrating the impact of changing business
conditions on the market’s evaluation of accounting information. Similar to the conclusions
drawn by Lev and Thiagarajan (1993), this study supports the importance of a contextual
analysis of ﬁnancial statement information.
The macroeconomics literature is used to document how different stages of the busi-
ness cycle—expansion, recession, credit crunch, and reliquiﬁcation—reﬂect variation in
the aggregate investing and ﬁnancing opportunity set. Variation in investing and ﬁnancing
opportunities implies variation in how the market uses information in earnings announce-
ments to revise expectations of future cash ﬂows. This variation leads to predictions about
intertemporal variation in earnings persistence and earnings response coefﬁcients (ERCs)
across business cycle stages.
Results from a sample of 53,324 quarterly earnings announcements by Value Line ﬁrms
over the period January 1970–September 1987 indicate that earnings persistence and ERCs
vary across the business cycle with changes in the aggregate investment opportunity set.