The declining association between earnings and returns: Diminishing value relevance of earnings or noisier markets?

Abstract

Purpose

This paper aims to identify what drives the temporal reduction in the value relevance of earnings documented in the literature. Is it the increasing noise in stock returns over time, noise in earnings, or both?

Design/methodology/approach

The authors develop hypotheses from the lead/lag structure between stock returns and accounting earnings and perform empirical tests using data from annual COMPUSTAT and monthly CRSP over the sample period of 39 years (1970‐2008).

Findings

The test results show that increasing noise in stock returns over time is primarily responsible for the temporal reduction of R² in regressions of returns on earnings. Additional analysis shows weak evidence that both the noise in returns and the noise in earnings are responsible for the declining association between earnings and returns in a sub‐period (1970‐1982).

Research limitations/implications

The R²‐based methodology has limitations because, as Gu points out, regression R²s might be incomparable across samples. The findings suggest that future research should control for the effects of the temporal increase in market noise before making value relevance inferences from the declining association between earnings and returns.

Originality/value

The paper contributes to the limited body of research on noise in stock returns as the main driver for the temporal reduction in value relevance of earnings.

Citation

Lim, S.C. and Park, T. (2011), "The declining association between earnings and returns: Diminishing value relevance of earnings or noisier markets?", Management Research Review, Vol. 34 No. 8, pp. 947-960. https://doi.org/10.1108/01409171111152538