The real-time information content of macroeconomic news: implications for firm-level earnings expectations

Abstract

This paper investigates the usefulness of the real-time macroeconomic news-flow as a leading indicator of firm-level end-of-quarter realized earnings. Using recent advances in macroeconomics, I develop a nowcasting model for quarterly earnings and provide two main findings. First, I show that my model provides out-of-sample expectations that are as accurate as analysts’ forecasts. Second, macroeconomic news embedded in my nowcasts is not fully incorporated into investors’ earnings expectations and predicts future abnormal returns around earnings announcements. These findings have three main implications for capital markets research. First, real-time macroeconomic news can be used to update earnings expectations in real-time. Second, there are economic benefits of doing so, as evidenced by the magnitude of risk-adjusted returns around earnings announcements. Third, after three decades of almost nonexistent research on time-series models for quarterly earnings, the door is open again for fruitful research in this area.

1 Introduction

Basically, there is a huge disconnect. But it’s not a disconnect between the economy and stocks. It’s a disconnect between the economy and earnings … What’s going on? EPS estimates just keep trending up. And GDP estimates keep going down. … ¹

A large portion (17% to 60%) of the variation in firm-level earnings is explained by contemporaneous macroeconomic conditions (Brown and Ball 1967; Fama 1990; Ball et al. 2009, among others). This evidence suggests that incorporating information about the contemporaneous state of the business cycle is likely to help predict current quarter realized earnings. For example, General Motors (GM) is a leading U.S. company that operates in the automobile industry, one of the most sensitive industries to business cycle fluctuations. On Feb. 4, 2015, GM announced 2014 fourth quarter earnings per share (EPS) of $1.19, compared to analysts’ I/B/E/S average estimate of $0.83. On Feb. 27, 2015, the Bureau of Economic Analysis announced that the U.S. Gross Domestic Product (GDP) increased at an annual rate of 2.2% in the fourth quarter of 2014.² Given the strength of fourth quarter GDP growth and the close link between GM earnings and the business cycle, could one have anticipated the strong earnings reported by GM?

Unfortunately, the prevailing macroeconomic conditions for a given fiscal quarter are not directly observable, and commonly used statistical proxies such as GDP are only known with a substantial lag.³ However, as a firm’s fiscal quarter evolves, there are a substantial number of other macroeconomic releases that contain information about current quarter’s macroeconomic conditions and that are released in a much timelier manner than GDP figures. Whether this flow of information is helpful for creating accurate and timely business cycle estimates that can be used to revise firm-level earnings expectations in real-time, is an empirical question and the focus of this paper.

A recent stream of nowcasting papers in macroeconomics shows that, as the fiscal quarter evolves, real-time macroeconomic releases can be used to obtain accurate and timely estimates of the contemporaneous state of the business cycle (Evans 2005; Giannone et al. 2008; Banbura et al. 2011).⁴ These findings are important and justify an investigation of their consequences for capital markets research for at least three reasons. First, they suggest that real-time macroeconomic releases could be particularly relevant for predicting corporate earnings, which are dependent on the business cycle and are released with a substantial lag.⁵ Second, these findings imply that there is room for developing nowcasting models for quarterly earnings that could compete with analyst forecasts. Similar to what analysts do, nowcasting models exploit very timely and contextual macroeconomic information.⁶ These innovations are likely to reduce the information and timing advantage of analysts and are going to be particularly relevant at very short forecasting horizons, precisely where the information and timing advantage of analysts is likely to be higher (Bradshaw et al. 2012).⁷ And third, the extent to which real-time macroeconomic releases are incorporated into market earnings expectations will shed further light on price discovery in equity markets.

This paper directly relates to at least two interconnected streams of research in accounting.⁸ First, it relates to the literature on time-series models for quarterly earnings (Griffin 1977; Foster 1977; Brown and Rozeff 1979; among others). These papers were primarily interested in evaluating the ability of different time-series models to accurately forecast earnings. Overall, the main finding emerging from this literature is that, although these models fit quarterly earnings data well, they are likely to provide less accurate forecasts than analysts (Brown et al. 1987). Second, this paper relates to the literature on fundamental analysis and market efficiency that links the time-series properties of quarterly earnings to future stock returns (Bernard and Thomas 1989, 1990; Bartov 1992; Ball and Bartov 1996). The main finding from this literature is that investors systematically omit firm-specific information when forming earnings expectations and that this systematic omission translates into future stock return predictability.⁹

The closest paper to this one is Giannone et al. (2008), who use the real-time information content of macroeconomic releases for nowcasting GDP. In this paper, I use the real-time information content of macroeconomic releases for nowcasting quarterly earnings. Further, I evaluate the extent to which market earnings expectations reflect the information content of macroeconomic news and its implications for stock return predictability. Surprisingly, despite the apparent importance of macroeconomic conditions in determining corporate earnings, the mechanism through which the former shape earnings expectations remains almost completely unexplored.¹⁰ The aim of my capital markets tests examining the information content of nowcasts is similar to that of Chordia and Shivakumar (2005). They show that the post-earnings-announcement drift is partially caused by investors’ not fully incorporating expected inflation into earnings expectations.¹¹ However, although inflation is informative about business cycles, there are other variables, such as interest rates and unemployment that also play an important role in determining business cycles. Moreover, all these variables are likely to be interrelated. In this study, I adopt a more comprehensive approach to model business cycles and evaluate its effect on earnings expectations.

This study makes several contributions. First, it contributes to the literature on time-series models for quarterly earnings by showing that my model provides out-of-sample expectations that are as accurate as analysts’ forecasts. This study also contributes to the market efficiency literature by showing that macroeconomic news embedded in my nowcasts is not fully incorporated into investors’ earnings expectations and predict future abnormal returns around earnings announcements.

The remainder of the paper is organized as follows. Section 2 describes the theoretical link among macroeconomic news, earnings expectations, and future stock returns. Section 3 describes the econometric framework for extracting macroeconomic news in real-time. Section 4 describes the empirical tests. Section 5 presents the results. Section 6 concludes.

2 Macroeconomic news, earnings expectations and stock returns

Figure 1 shows a stylized example describing the flow of macroeconomic information for the typical fiscal quarter and how this information can be used to update earnings expectations in real-time. In the timeline, the fiscal quarter starts at q − 1 and finishes at q. For simplicity, I will assume a hypothetical scenario in which a single macroeconomic indicator (BC _q ) captures the overall state of the business cycle and also assume that this indicator is released without any publication lag.¹²

Fig. 1

Macroeconomic news and earnings nowcasts

Earnings (X_{i, q}) are a quarterly variable, which is typically released with considerable lag. Depending on each firm, it could take up to three months after the fiscal quarter-end for earnings to be released. In my timeline, I will assume that the typical company will schedule the earnings announcement for quarter q (EA _q ) one month after the end of the fiscal quarter.

Previous research has documented that a large portion (17% to 60%) of the variation in firm-level earnings is explained by contemporaneous macroeconomic conditions (Brown and Ball 1967; Fama 1990; Ball et al. 2009; among others). This evidence suggests that one can decompose a firm’s seasonally adjusted earnings as:

$$ {X}_{i,q}-{X}_{i,q-4}={\beta}_{i,q}{BC}_q+{u}_{i,q} $$

(1)

where X_{i, q} is the end-of-quarter earnings, BC _q is the seasonally adjusted change in the business cycle, β_{i, q} is the firms’ earnings sensitivity to BC _q , and u_{i, q} is the change in earnings resulting from sources orthogonal to BC _q .¹³

This decomposition of earnings implies that, to predict (nowcast) end-of-quarter earnings, one would need to predict β_{i, q}BC _q as well as u_{i, q}. For example, consider the nowcasting exercise at month m₁ of quarter q of a financial analyst who wants to nowcast end-of-quarter earnings, X_{i, q}. Based on equation (1) and leaving the prediction of u_{i, q} aside, an efficient nowcast of next quarter’s X_{i, q} − X_{i, q − 4} made at time m₁ would be:

$$ \underset{NOWCAST_{i,q\mid {m}_1}}{\underbrace{E\left({X}_{i,q}-{X}_{i,q-4}|{m}_1\right)}}=E\left({\beta}_{i,q}{BC}_q|{m}_1\right)={\widehat{\beta}}_{i,q}E\left({BC}_q|{m}_1\right) $$

(2)

where E(.) is the expectation operator, and E(X_{i, q} − X_{i, q − 4}| m₁) is the earnings nowcast (${NOWCAST}_{i,q\mid {m}_1}$). The earnings nowcast is simply the business cycle nowcast (E(BC _q | m₁)), modified to include an estimate of the firm’s sensitivity to the business cycle (${\hat{\beta}}_{i,q}$).¹⁴ As the fiscal quarter evolves and more information about the business cycle becomes available, earnings nowcasts are subsequently updated to reflect the new information impacting the business cycle nowcasts. Thus, at time m₂, an updated earnings nowcast would be:

$$ {NOWCAST}_{i,q\mid {m}_2}={\widehat{\beta}}_{i,q}E\left({BC}_q|{m}_2\right) $$

(3)

and the same updating will occur after the remainder of the macroeconomic releases throughout the quarter.

Equation (1) forms the basis of my empirical analysis, and it captures the idea that earnings expectations should be revised together with expectations about the business cycle. An implication of equation (1) is that, if for example, equity investors revise their expectations about the business cycle with a lag, E^M(BC _q | m₃) = E(BC _q | m₂), where E^M(.) represents market expectations, then NEWS _q  ∣ m₃ will predict market earnings forecast revisions.¹⁵ Moreover, this predictability will translate into future stock return predictability. This is, the market forecast revision at the earnings announcement date will be:

$$ {X}_{i,q}-{E}^M\left({X}_{i,q}|{m}_3\right)={\widehat{\beta}}_{i,q}\left[{BC}_q-E\left({BC}_q|{m}_2\right)\right]={\widehat{\beta}}_{i,q}\left({NEWS}_q|{m}_3\right) $$

(4)

and the abnormal return, AR_{i, q} = γ_{i, q}(NEWS _q | m₃).

3 Macroeconomic information flow

3.1 Macroeconomic announcements calendar

Extending Section 2, in which I consider only one macroeconomic indicator, this section will describe a more general setup with many macroeconomic indicators. To track the real-time macroeconomic news flow, I follow the procedure outlined in Giannone et al. (2008). First, I develop a monthly stylized calendar of macroeconomic releases. This calendar serves two purposes. It aids in the identification of the main macroeconomic releases that occur within a given calendar month, and it serves to categorize the announcements by publication dates and information content. Second, I use the sequence of macroeconomic releases, as implied by the publication dates of the stylized calendar, to replicate the real-time flow of macroeconomic information through the quarter. This process serves to create a series of pseudo real-time macroeconomic information sets.¹⁶

To construct the stylized calendar, I obtain the timing and structure of the macroeconomic releases from the economic calendar provided by Bloomberg.¹⁷ Because macroeconomic releases are structured roughly in the same manner each month, I use a stylized month for all months in my sample. I consider approximately 35 distinct data releases of approximately 160 macroeconomic indicators every month, with a number of macroeconomic variables being released on the same date. Because numerous macroeconomic releases occur during the month, to keep track of the information in a comprehensive manner, I group these 160 monthly releases into 15 “blocks” based on the publication dates and information content of each release. Because all macroeconomic indicators grouped in a given block roughly share the same information and publication dates, for modeling purposes, I can treat them as one single indicator.¹⁸

Once the blocks are defined and the timing of releases identified, I use the stylized calendar to replicate the real-time availability of macroeconomic information through the quarter. Specifically, for each month in my sample, I use only previously available information to create monthly “pseudo point-in-time” expanding information sets. Subsequent information sets will differ from the previous one in that they will contain the new figures for all macroeconomic indicators released for the current month. The process is repeated afterwards for each month of the current quarter, and it continues for all quarters in my sample until I create the last information set of the sample which includes all previous historical information.

3.2 Econometric framework

My econometric framework follows the work of Giannone et al. (2008) closely. This framework exploits the well-known empirical stylized fact that business cycles are characterized by the co-movement of a large number of macroeconomic indicators (Stock and Watson 1989). Accordingly, I decompose my panel of macroeconomic series into a latent common dynamic factor and the series’ idiosyncratic components:

$$ {M}_{i,m}={\mu}_i+{\beta}_i{BC}_m+{\xi}_{i,m} $$

(5)

where M_{i, m} denotes the monthly macroeconomic series that have been transformed in stationary processes, μ _i and β _i are the series specific constant and factor loading, BC _m is the series latent common dynamic factor, and ξ_{i, m} are the idiosyncratic components. Finally, to be able to compute forecasts, I allow the latent common dynamic factor to vary through time by parameterizing its dynamics as an AR (1) process:

$$ {BC}_m=\lambda {BC}_{m-1}+{e}_m\kern2em {e}_m\sim N\left(0,I\right) $$

(6)

Within this framework, BC _m represents the state of the business cycle, and my main interest is to compute expectations about the end-of-quarter business cycle E(BC _q ), conditional on each of the information sets I described in the previous section, Ε(BC _q | m). This forecasting exercise results in one pseudo real-time business cycle estimate for any given month.

Finally, to estimate firm-level sensitivities β_{i, q} and create the firm-level nowcasts, I use the time-varying parameter structure in earnings described in equation (1). This earnings representation can be written in state-space form, where β_{i, q} is the unobserved latent variable that is assumed to follow an AR(1) process:

$$ {\beta}_{i,q}={\beta}_{i,q-1}+{\theta}_{i,q}\kern2em {\theta}_{i,q}\sim N\left(0,1\right) $$

The time-varying parameter regression in equation (1) is standard in time-series econometrics, and ${\widehat{\beta}}_{i,q}$ estimates can be computed via a Kalman filter.¹⁹ Importantly, this model specification implies that the ${\widehat{\beta}}_{i,q}$ estimates are constructed using information that is available before q, and consequently the nowcast is completely out-of-sample. In my capital market tests, I will mostly focus on the business cycle nowcasts available at the end of the fiscal quarter q, which, to simplify notation, I will label as Ε(BC _q | q) ≡ Ε(BC _q ). This business cycle nowcast coupled with the ${\widehat{\beta}}_{i,q}$ estimate, will combine to produce the firm-level nowcast available at the end of the fiscal quarter q, ${NOWCAST}_{i,q}={\widehat{\beta}}_{i,q}E\left({BC}_q\right)$. Appendix 1 provides the timeline describing the timing at which ${NOWCAST}_{i,q}$ is measured.

4 Empirical tests and data

So far, I have described the theoretical framework and the empirical measurement of my main variable of interest, ${NOWCAST}_{i,q}$. In the following section, I will describe the empirical tests to assess the information content of ${NOWCAST}_{i,q}$.

4.1 Univariate tests

In this section, I evaluate the out-of-sample accuracy of analysts’ forecasts and compare it to that of the nowcasts. To evaluate the accuracy of these expectations, I used the mean forecast error (MFE) and the mean squared forecast error (MSFE). For every firm-quarter in my sample, I calculate MFE (MSFE) as the average of the (squared) difference between realized end-of-quarter earnings and analysts’ forecasts (AF) or the nowcasts. Finally, I test for significant differences using standard difference-in-mean tests.

4.2 Multivariate capital markets tests

4.2.1 End-of-quarter earnings and nowcasts

In the first set of multivariate tests, I evaluate the predictive power of ${NOWCAST}_{i,q}$ for predicting end-of-quarter seasonally adjusted earnings, after controlling for other earnings expectations proxies. To do so I estimate the following regression model:

$$ {SUE}_{i,q}={a}_0+{b}_1{NOWCAST}_{i,q}+E\left[{SUE}_{i,q}\right]+{e}_{i,q} $$

(7)

where SUE_{i, q} is seasonally adjusted earnings for company i and quarter q, scaled by end-of-quarter stock price, $E\left[{SUE}_{i,q}\right]=\sum \limits_{k=1}^4{b}_{1+k}{SUE}_{i,q-k}$ or E[SUE_{i, q}] = b₂AF_{i, q}, where AF_{i, q} is the analyst forecast. In Appendix 1, I provide further details on variable definitions.

The model in equation (7) is based on the economic framework provided in Section 2. Under the assumption that earnings follow the process described in equation (1), SUE_{i, q} would be a function of the contemporaneous state of the business cycle (${NOWCAST}_{i,q}$) plus some firm-specific earnings information. If ${NOWCAST}_{i,q}$ provides additional information regarding seasonally adjusted earnings that is not already reflected in lagged seasonally adjusted earnings or analysts’ forecasts, then one would expect b₁ ≠ 0.²⁰

4.2.2 Nowcasts and future stock returns

In the second set of multivariate tests, I study how the stock market prices the information content of lagged quarterly earnings, analysts’ forecasts and ${NOWCAST}_{i,q}$. On the earnings announcement date, the market reacts to the unexpected component of earnings. If market expectations do not contain information on ${NOWCAST}_{i,q}$, then the stock price reaction around earnings announcements will be a function of the ${NOWCAST}_{i,q}$. The intuition for this argument is straightforward: if quarterly earnings partially depend on current quarter macroeconomic conditions, then, assuming that companies’ sensitivities to the business cycle are positive, good news during the quarter will lead to higher earnings, and bad news will lead to lower earnings. If the market fails to fully update expectations accordingly, then the market will be positively surprised after a quarter of good news and negatively surprised after a quarter of bad news. To test this conjecture, I estimate the following model:

$$ {CAR}_{i,q}={a}_0+{\gamma}_1{NOWCAST}_{i,q}+E\left[{SUE}_{i,q}\right]+{u}_{i,q} $$

(8)

where CAR_{i, q} is the cumulative abnormal return of company i and quarter q during the three-day window beginning one day before the earnings announcement and ending one day after. For consistency with previous literature, in the announcement returns regressions and the corresponding forecasting regressions, independent variables are transformed into decile ranks.²¹

4.3 Data

4.3.1 Macroeconomic data

The macroeconomic data consist of more than 160 macroeconomic indicators for the US economy from January 1982 to December 2015.²² The indicators include real variables, financial variables, prices, wages, money and credit aggregates, surveys, and other indicators.²³ The variables are selected on the basis of the calendar of economic releases provided by Bloomberg. The aim is to capture the bulk of variables that are followed by market participants and that may influence earnings forecasts revisions. The macroeconomic variables are aligned in time to ensure that they are available at the time analyst forecasts are issued and before earnings announcements. Details on the macroeconomic indicators, the block structures, and the approximate timing of the releases are available in Appendix 2.

4.3.2 Earnings, analyst forecasts and stock return data

I use the intersection of US Compustat, the US I/B/E/S unadjusted summary and US CRSP data files to create my sample. Consistent with prior literature on the time-series properties of earnings, I require a minimum of 20 consecutive time-series earnings observations for a firm to be in my sample.²⁴ In the task of selecting firms with sufficient time-series earnings observations, one could select firms using actual earnings from Compustat or from I/B/E/S. To avoid arbitrary decisions and for robustness, I create two datasets. The construction of the two datasets only differs in whether I sample observations based on Compustat or I/B/E/S actuals.²⁵ To measure earnings, I use earnings-per-share (before extraordinary items) and analysts’ forecasts are one-quarter-ahead earnings-per-share mean consensus forecasts from the I/B/E/S unadjusted summary file.²⁶

Subsequently, I extract daily returns from CRSP and compute cumulative abnormal returns (CARs) surrounding earnings announcement dates. CARs are calculated by assigning stocks into six size/book-to-market portfolios calculated based on the methodology outlined on Ken French’s website.²⁷ Returns include delisting returns and are accumulated over a three-day window centered at the earnings announcement date.

I impose the following filters on my data: (1) nonmissing observations for the variables in my regressions; (2) I eliminate non-March, June, September or December fiscal quarter-ends; (3) I eliminate stocks with prices lower than $1; and (4) I eliminate top (bottom) 0.5% of observations for each quarter/variable in my regression. For the Compustat-CRSP sample, I obtain 174,641 firm-quarter observations with nonmissing observations. This sample represents 82.09% of the total market capitalization, when no requirement about nonmissing observations is imposed. I then eliminate 26,232 firm-quarter observations corresponding to noncalendar fiscal quarters and stocks with prices below $1. Finally, I eliminate 5,327 outlier observations, to obtain a final Compustat-CRSP sample of 143,082 firm-quarter observations that represents 70.33% of total market capitalization, when no data restrictions are imposed. Following the same procedure, I obtain a final I/B/E/S-CRSP sample of 68,887 firm-quarter observations that represents 55.30% of total market capitalization of the Compustat-CRSP sample when no data restrictions are imposed. Importantly, although both samples differ in their respective number of observations, the differences are smaller when considering the percentage of the total market capitalization that they represent.²⁸ A detailed explanation of the sample construction and composition is provided in Tables 1 and 2, and a timeline for variable measurement is provided in Appendix 1.

Table 1 Sample construction

Table 2 Sample industry composition

5 Results

5.1 Descriptive statistics and univariate tests

As described in section 3.2, NOWCAST_{i, q} is the combination of a business cycle nowcast and an estimate of firm’s sensitivity to the business cycle. Therefore a key ingredient of my firm-level nowcasts is the typical business cycle nowcast used in the macroeconomics literature, which I need to estimate in this paper. To provide some evidence about what these macro nowcasts capture, I replicate the Giannone et al. (2008) results and run their bridge regression, where GDP growth is the dependent variable and the output from their factor model is the independent variable and plot these results in Fig. 2. The figure shows the fitted values of this bridge regression (GRS-based nowcast), in addition to those obtained with alternative variables. As an alternative to the the Giannone et al. (2008) factor model, I use a publicly available variable, the Chicago Fed National Activity Index (CFNAI), which resembles the latter factor. In these regards, the CFNAI-based nowcast is the fitted value of a regression, where GDP growth is the dependent variable and the CFNAI the independent variable. Finally, I also plot the GDP nowcasts provided directly by the Survey of Professional Forecasters.²⁹

Fig. 2

Business cycle factor model: realized and expected GDP Growth. This figure shows the performance of the dynamic factor model in capturing business cycle fluctuations as measured by the annualized seasonally adjusted GDP growth rate. GRS-based nowcast represents the fitted values from a regression of the quarterly annualized seasonally adjusted GDP growth rate on the contemporaneous business cycle factor described in Section 3. SPF Nowcast represents the nowcast by the Survey of Professional Forecasters. CFNAI-based nowcast represents the fitted values from a regression of the quarterly annualized seasonally adjusted GDP growth rate on the contemporaneous CFNAI indicator. GDP-Growth represents the realized quarterly annualized seasonally adjusted GDP growth rate

As evident in Fig. 2, Panel A, the factor model captures the dynamics of the business cycle well. Most importantly, by construction, the model delivers a very timely business cycle indicator that is available well before the release of the GDP and before companies report their quarterly earnings. Panels B and C, show how the alternative CFNAI and SPF nowcasts track the business cycle.³⁰

Table 3 presents summary statistics, and the results of univariate tests assessing the accuracy of ${NOWCAST}_{i,q}$, relative to AF_{i, q}. Overall, the results in Table 3 indicate that ${NOWCAST}_{i,q}$ is as accurate as AF_{i, q} (difference in MFE is negative −0.02 and insignificant with a t-statistic of −0.82; difference in MSFE is positive 0.01 and insignificant with a t-statistic of 0.05).

Table 3 Summary statistics and univariate tests

5.2 Multivariate capital markets tests

5.2.1 End-of-quarter earnings and nowcasts

Table 4 presents regression results for seasonally adjusted quarterly earnings and nowcasts. I estimate model (7) using Fama and MacBeth (1973) regressions and Newey-West standard errors with a four lag correction.³¹ Column (1) presents the results when lagged earnings variables are the only explanatory variable in the regression. I find that seasonally adjusted earnings are highly auto-correlated, as shown by the coefficients on the first four lags (0.46, 0.11, 0.03, and −0.18, with t-statistics of 36.08, 13.78, 4.41, and −20.39, respectively). This declining pattern in the serial correlation of seasonally adjusted earnings is consistent with previous studies—see, for example, the work of Bernard and Thomas (1990), who report autocorrelations of 0.34, 0.19, 0.06, and −0.24. Column (2) presents the results when only one-lag seasonally adjusted earnings is the explanatory variable and find that this variable captures the bulk of information in previous four lags (R-squared of 3.16%, relative to 4.58% for the full specification).

Table 4 Seasonally adjusted quarterly earnings and nowcasts (I/B/E/S-CRSP)

Column (3) presents the results when ${NOWCAST}_{i,q}$ is the only explanatory variable for end-of-quarter earnings. ${NOWCAST}_{i,q}$ is highly positively significant (point estimate of 0.75 and t-statistic of 35.63) and explains 12.08% of the variation in end-of-quarter earnings as per the regression R-squared. This R-squared is large, when compared to the explanatory power of standard time-series models.

Finally, in Column (4), I compare SUE_{i, q − 1} and ${NOWCAST}_{i,q}$ and find that ${NOWCAST}_{i,q}$ is incremental to lagged earnings, as evidenced by a highly significant point estimate of 0.74 with a t-statistic of 46.82.

Table 5 presents the regression results for seasonally adjusted quarterly earnings, analysts’ forecasts, and nowcasts. For these tests, I estimate model (7) where E[SUE_{i, q}] = b₂AF_{i, q}. Column (1) presents the results when AF_{i, q} is the only explanatory variable in the regression. As expected, I find that AF_{i, q} strongly anticipates end-of-quarter seasonally adjusted earnings (point estimate of 0.78 with a t-statistics of 38.05).

Table 5 Seasonally adjusted quarterly earnings, analysts’ forecasts and nowcasts (IBES-CRSP)

Column (2) parallels Column (3) of Table 4 and Column (3) presents the results when both AF_{i, q} and ${NOWCAST}_{i,q}$ are included in the regression. Interestingly, I find that the predictive power of ${NOWCAST}_{i,q}$ is incremental to that of AF_{i, q}. With respect to ${NOWCAST}_{i,q}$ I find a highly significant point estimate of 0.33 with a t-statistic of 10.42. This result is also economically significant, given the reduction in the magnitude of the AF_{i, q} coefficient.

The findings in Table 4 suggest that there is significant information content in ${NOWCAST}_{i,q}$ not captured by previous time-series models. From the results in Table 5, it seems that, although ${NOWCAST}_{i,q}$ and AF_{i, q} could serve as standalone expectations for end-of-quarter earnings, they capture two different dimensions of the information that anticipates end-of-quarter earnings: a macro-level content in ${NOWCAST}_{i,q}$ and probably a more firm-specific content in AF_{i, q}.

Because most of the cross-sectional variation in NOWCAST_{i, q} comes from firm-level earnings sensitivity to the business cycle $\left({\hat{\beta}}_{i,q}\right)$, a priori one could think that the variation in ${NOWCAST}_{i,q}$ (and hence its cross-sectional forecasting power) is likely to be small. However, one could also think that ${\widehat{\beta}}_{i,q}$ has a transitory component that could lead to short-term fluctuations in earnings, due to short-term fluctuations in the business cycle.³² These short-term fluctuations in ${\widehat{\beta}}_{i,q}$ are likely to induce short-term cross-sectional variation in earnings. As shown in Tables 4 and 5, a nowcasting model could be particularly relevant for modelling these short-term fluctuations in earnings. In analogous terms, very much like an analyst reads and interprets a continuous flow of information to produce forecasts, the nowcasting model reads and interprets the macroeconomic information flow to produce nowcasts.

Because I aim to make fair comparisons about the information content of lagged seasonally adjusted earnings, analysts’ forecasts and nowcasts, so far I have primarily focused on my I/B/E/S-CRSP.³³ In Table 6, I repeat my main tests using the larger, arguably more generalizable Compustat-CRSP sample. Column (4) shows that ${NOWCAST}_{i,q}$ has substantial information content for end-of-quarter seasonally adjusted earnings (positive coefficient of 0.49 with a t-statistic of 63.73), after controlling for the information content of lagged earnings.

Table 6 Seasonally adjusted quarterly earnings and nowcasts (COMPUSTAT-CRSP)

Overall, the results so far highlight not only the importance of the macroeconomic environment in explaining end-of-quarter seasonally adjusted earnings but also, and perhaps more importantly, the fact that my nowcasting model can deliver out-of-sample earnings expectations that are as accurate as analysts’ forecasts. These results are important, as the literature on time-series models for quarterly earnings culminated in the mid 1980s with the conclusion that analysts’ forecasts are superior to time-series forecasts because analysts possess both an information and a timing advantage. My findings suggest that, with the recent developments in time-series econometrics, this might no longer be the case. Thus it seems that the door is open again for future research on time-series models for quarterly earnings.

5.2.2 Future stock returns and nowcasts

In this section, I explore stock returns around quarterly earnings announcements to determine the extent to which investors incorporate the information content of ${NOWCAST}_{i,q}$ into earnings expectations.

There are reasons to believe that the stock market may not correctly incorporate macroeconomic news flow into earnings expectations. For example, Chordia and Shivakumar (2006) show that returns to portfolios formed on the basis of seasonally adjusted earnings are correlated with future macroeconomic conditions. A potential explanation for this finding is provided by Chordia and Shivakumar (2005), who demonstrate that these returns result because stock market investors fail to correctly incorporate inflation into earnings expectations. If the former result is a particular case of a more general macroeconomic mispricing, then the stock market might fail to fully incorporate macroeconomic news into earnings expectations.

To analyze the pricing implications of ${NOWCAST}_{i,q}$, I first estimate the implied weights investors give to different sources of information to determine whether these sources are correctly priced. In doing so, I will focus on SUE_{i, q − 1} and ${NOWCAST}_{i,q}$, as not only do the results reported in Table 4 demonstrate that these combine to produce earnings expectations that explain well the variation in realized earnings but also it will facilitate interpretation of the results.³⁴ To estimate investors’ implied weights, I follow Ball and Bartov (1996) and Kraft et al. (2007) and run the regression in equation (8), in which I include the contemporaneous SUE_{i, q} in addition to the lagged SUEs and ${NOWCAST}_{i,q}$.³⁵

The results are presented in Table 7. Panel A presents the forecasting parameters of Table 6, and Panel B presents the valuation parameters inferred from stock prices. Panel C formally tests for differences. In Columns (1)–(2), I find that, when looking at lagged earnings and nowcasts independently, prices seem to behave as if investors underreact to the information content of SUE_{i, q − 1} and ${NOWCAST}_{i,q}$. (Differences in the forecasting and valuation coefficients are highly and positively significant at all confidence levels.) These results are consistent with previous studies suggesting that investors seem to underreact to previous earnings information.

Table 7 Inferring forecasting parameters implied in stock prices (Compustat-CRSP)

In my forecasting results in Tables 4 and 6, Column (4), I find that both SUE_{i, q − 1} and ${NOWCAST}_{i,q}$ predict future SUE_{i, q}. However, it seems that a significant amount of information in SUE_{i, q − 1} is subsumed by ${NOWCAST}_{i,q}$. Therefore an efficient expectation for SUE_{i, q} should give a relatively higher weight to ${NOWCAST}_{i,q}$ than to SUE_{i, q − 1}. In the pricing tests in Table 7, Column (3), I find that conditionally on the information in ${NOWCAST}_{i,q}$, investors give too much weight to SUE_{i, q − 1} than what it is justified by the forecasting results. In addition, I find that investors underreact to ${NOWCAST}_{i,q}$. Overall, these findings imply that future returns around earnings announcements would be positively related to ${NOWCAST}_{i,q}$ and SUE_{i, q − 1} in independent regressions but positively related to ${NOWCAST}_{i,q}$ and negatively related to SUE_{i, q − 1}, when combined in the same regression.

Table 8 reports the results of lagged seasonally adjusted quarterly earnings and nowcasts as predictive variables for earnings announcement returns. As before, I estimate model (8) by running Fama and MacBeth (1973) regression and base my inferences on t-statistics calculated with four-lag Newey-West standard errors.³⁶

Table 8 Future stock returns, lagged earnings, and nowcasts (Compustat-CRSP)

Column (2), shows that, as predicted from the results in Table 7, stock prices behave as if investors underreact to the information in ${NOWCAST}_{i,q}$ (coefficient of 0.46 with a t-statistic of 4.55). Similarly, when ${NOWCAST}_{i,q}$ is combined with SUE_{i, q − 1}, stock prices behave as if investors underreact to the information in ${NOWCAST}_{i,q}$ (coefficient of 0.56 with a t-statistic of 5.87) but overreact to SUE_{i, q − 1} (coefficient of −0.17 with a t-statistic of −1.93).

Finally, I assess whether the results from Table 8 could be extended into a trading strategy that yields a well-diversified long-short portfolio and report the results in Table 9. For this analysis, I compute nowcast-based hedge portfolio returns across time and run time-series regressions, where the dependent variable is the hedge returns, NOWCAST (L/S) _q , and the independent variables are the typical return factors: MKT-RF, SMB, HML, RMW, CMA, and MOM.³⁷ As the table shows, an investor who, for every month of the quarter and before earnings announcements, buys (short-sells) the stocks in the top (bottom) decile of ${NOWCAST}_{i,q}$ and holds that portfolio until the day after the earnings announcement could have earned a monthly-equivalent five-factor alpha of around 0.85%.³⁸ In addition, I show that the strategy’s alpha is robust to momentum returns and the returns of an equivalent trading strategy, SUE (L/S) _q , that instead exploits the information in SUE_{i,q − 1}. Finally, the results show that the NOWCAST (L/S) _q strategy provides a well-diversified portfolio that is unlikely to load on common risk factors, as suggested by the almost insignificant, or even negative, risk factor loadings. These results suggest that there are significant economic benefits associated to ${NOWCAST}_{i,q}$ and that these benefits exceed those provided by previous earnings information.³⁹

Table 9 Calendar-time long-short portfolio returns

5.2.3 Robustness check: Li et al. (2014) MACRO_{i, q} variable

Li et al. (2014) also use macroeconomic information for firm-level profitability forecasting. Specifically, they combine firm-level geographic segment data with forecasts of country-level performance to generate superior profitability forecasts. While their focus is on examining firms’ country exposures for longer horizon forecasting, I focus on domestic firms’ exposure and shorter term nowcasting. The focus on domestic exposure and shorter term nowcasting is fundamentally rooted on this paper’s research question. I seek to develop a new model for quarterly earnings that, by including contemporaneous macroeconomic information, can compete with analysts’ forecasts. Along these lines, the inclusion of contemporaneous information aims at reducing the timing advantage of analysts, and the inclusion of macroeconomic information aims at reducing their information advantage.

Even though my paper differs fundamentally from the work of Li et al. (2014), their MACRO_{i, q} variable includes a domestic component. Thus, in this section, I test whether the domestic shock in MACRO_{i, q} subsumes that of ${NOWCAST}_{i,q}$.⁴⁰ I present the results of this test in Table 10. The results show that MACRO_{i, q} does not subsume the information content of ${NOWCAST}_{i,q}$ in predicting SUE_{i, q}.

Table 10 Robustness check: controlling for the Li et al. (2014) MACRO variable

5.2.4 Robustness check: real-time nowcasting with the Chicago fed national activity index

A potential weakness of my empirical design is the revisions affecting the macroeconomic series. The framework of Giannone et al. (2008) does not take into account vintage macroeconomic series; however, they show that, under suitable assumptions, their framework is robust to data revisions. (See Giannone et al. (2008) for a discussion on this point.)

Nevertheless, to check the robustness of my results, I conduct additional tests employing vintage macroeconomic series. For this I use the real-time Chicago Fed National Activity Index (CFNAI), which is an index akin to the factor model of Giannone et al. (2008).⁴¹ The CFNAI is a monthly index estimated as the first principal component of 85 macroeconomic data series and is essentially a weighted average of the indicators (Brave and Butters 2014). The CFNAI offers both advantages and disadvantages over the factor model of Giannone et al. (2008). On one hand, one can construct a real-time version of the index, as there are CFNAI vintages available from March, 2001. On the other hand, the index is static and exploits the information of 85 variables, while the Giannone et al. (2008) factor model is dynamic and exploits the information of a significantly larger number of variables.⁴² To construct the real-time CFNAI index, I collect information on the most recent values for each vintage series of the CFNAI Historical Dataset and combine them into a single real-time series.

Table 11 presents the results for the main analyses when ${NOWCAST}_{i,q}$ is obtained from this purely real-time business cycle indicator. As evident from the table, the results are similar to those in the main baseline tests and consistent with those of Liebermann (2014), who shows that the Giannone et al. (2008) nowcasting framework is robust to data revisions in macroeconomic series.

Table 11 Robustness check: real-time nowcasting with the Chicago fed national activity index (CFNAI)

6 Conclusion

I exploit the real-time information content of macroeconomic news to develop a nowcasting model for firm-level end-of-quarter earnings and provide two main findings. First, I show that my model provides out-of-sample expectations that are as accurate as analysts’ forecasts. Second, macroeconomic news embedded in my nowcasts is not fully incorporated into investors’ earnings expectations and predicts future abnormal returns around earnings announcements. These findings have three main implications for capital markets research. First, they suggest that real-time macroeconomic information can be used to update earnings expectations in real-time. Second, there are economic benefits of doing so, as stock prices seem to behave as if investors do not fully impound the information content of macroeconomic news into earnings expectations. By linking this continuous flow of macroeconomic information with future stock returns, my study enhances our understanding of price discovery in equity markets. Third, these findings open the door for fruitful research on time-series models for quarterly earnings, in particular, for research on nowcasting models. Similar to the information set used by analysts, these nowcasting models can exploit very timely and macroeconomic contextual information. The ability to exploit very timely and macroeconomic contextual information has been suggested as the main reason for the superiority of analysts over time-series (Brown et al. 1987). These advancements are going to be particularly relevant at very short horizons, precisely when the information and timing advantage of analysts is likely to be higher (Bradshaw et al. 2012).

My paper leaves some unanswered questions for future research. For example, my empirical design models firms’ sensitivities to the business cycle as an unobserved latent process. Future research could try to understand the firm-characteristics that are more likely to affect firms’ sensitivities to the business cycle and incorporate those insights into this paper’s nowcasting framework.

Appendices

Appendix 1

Table 12 Variable definitions

Appendix 2

Table 13 Stylized calendar