CFS021002HK-ZWE391ql

Predicting Stock Market Returns with

Aggregate Discretionary Accruals
Qiang Kang, University of Miami
Qiao Liu,
University of Hong Kong
Rong Qi,
St. Johns University
2006 NTUICF
December 2006

Presentation Outline

Motivations
Research Questions
Data and Variables
Do Aggregate Discretionary Accruals Predict Stock Market Returns?
What Account for Aggregate Discretionary Accruals Return
Predictability?
Conclusion and Future Research

Motivations
Managerial Market Timing
Aggregate corporate decision

variables such as aggregate investment

plans (Lamont 2000); IPOs (Baker and
Wurgler 2000); insider trading
(Lakonishok and Lee 2001) are able to
predict stock market returns.
Earnings management, measured by
(discretionary) accruals, is routine
decision subject to a great deal of
discretion. Then, do aggregate earnings
management decisions predict stock
market returns?
Modern markets show microefficiency but considerable macroinefficiency (Shiller 2001; Lamont and
Stein 2006).

The Discounted-Cash-Flow Model

Aggregate earnings have little

predicative power (Kothari, Lewellen,

and Warner 2005). Not sure whether
another component of cash flow
accruals has predicative power.
Especially, it has been suggested that
accruals/discretionary accruals are able
to predict stock returns at firm- and
portfolio- levels (Sloan 1996; Xie
2001).
Some preliminary evidence shows
that total accruals do predict market
returns (Hirshleifer, Hou, and Teoh,
2005). But reasons remain unclear.

Presentation Outline

Motivations
Research Questions
Data and Variables
Do Aggregate Discretionary Accruals Predict Stock Market Returns?
What Drives Aggregate Discretionary Accruals Return
Predictability?
Conclusion and Future Research

This Paper Mainly Attacks Three Questions

Do

aggregate accruals predict stock

market returns?
What drives aggregate accruals
return predictability --- normal
accruals vs. discretionary accruals?
What accounts for aggregate
accruals return predictability --testing equity market timing
hypothesis

The Focus of
Our Empirical
Analysis!

Presentation Outline

Motivations
Research Questions
Data and Variables
Do Aggregate Discretionary Accruals Predict Stock Market Returns?
What Account for Aggregate Discretionary Accruals Return
Predictability?
Conclusion and Future Research

Variables
Accruals measures
We apply the balance sheet method
(Sloan 1996)

Other variables
Market returns annual returns on

both equal weighted and value weighted

NYSE/AMEX indexes in excess of the
one-month Treasure bill rate from 1965
to 2004.

Normal vs. Discretionary Accruals

The predicted value is normal accrual, while

the residual is defined as discretionary
accrual

We use both equal-weighting method

and value-weighting method to
aggregate accruals and normal or
discretionary accruals

The commonly used return predictors

include:
Dividend yield (DP); Term premium
(TERM); Default premium; Short rate
(TB1M); stochastically-detrended short
rate (SHORT); The consumption-wealth
ratio (CAY); equal-weighted and value
weighted book-to market ratio; equity
shares in new issues (S); investor
sentiment index (SF2RAW); aggregate
corporate investment plans (GHAT)

The Dynamics of Aggregate Accruals Measures across Time

Data
CRSP

Compustat
The DRI database: TERM, DEF
Martin Lettaus website: CAY
Jeffery Wurglers website: S, SF2RAW
Owen Lamonts website: GHAT

Summary Statistics Panel A of Table 1

Panels B and C of Table 1

Presentation Outline

Motivations
Research Questions
Data and Variables
Do Aggregate Discretionary Accruals Predict Stock Market Returns?
What Account for Aggregate Discretionary Accruals Return
Predictability?
Conclusion and Future Research

First of all, we need to establish that small-sample bias is not a

big concern
We test the null hypothesis of no stock return predictability by creating 50,000 serioes of value-weighted
market return based on the following system and then do OLS

Value-Weighted Aggregate Accruals are a predictor of Stock Market

Return Panel A of Table 2

Value-weighed
aggregate accrual is
one robust predictor!

And, Aggregate Accruals' return predictability is solely driven by

aggregate discretionary accruals, not normal accruals Univariate
Analysis

Value-weighted aggregate
discretionary accruals explain
excess stock market returns!

And, Aggregate Accruals' return predictability is solely driven by

aggregate discretionary accruals, not normal accruals Multivariate
Analysis

Value-weighted aggregate
discretionary accruals return
predictability is robust to
inclusion of other know
predictors.

Presentation Outline

Motivations
Research Questions
Data and Variables
Do Aggregate Discretionary Accruals Predict Stock Market Returns?
What Account for Aggregate Discretionary Accruals Return
Predictability?
Conclusion and Future Research

Market Efficiency Argument I: Testing Omitted Factor Hypothesis

There is only one-directional Granger causality form the value-weighted

(discretionary) accruals to the aggregate stock market returns. The omitted
factor hypothesis, which implies a bi-directional Granger causality between
the two, lacks the empirical support!

Market Efficiency Argument II: Aggregate accruals as Proxies for

Business Conditions

Aggregate normal accruals are a predictor of GDP growth. But valueweighted aggregate discretionary accruals are not!!!

Using Value-Weighted Discretionary Accruals to Predict Market

Excess Return

Using Value-Weighted Discretionary Accruals to Predict Market

Excess Return

Aggregate Discretionary Accruals Predicting NEGATIVE Market Return

Suggests Market Inefficiency

We Apply the GMM Estimation To Explore the Contemporaneous Relations

between Aggregate Accruals and Aggregate Market Returns

We Apply the GMM Estimation To Explore the Contemporaneous Relations

between Aggregate Accruals and GDP Growth Rate

The Aggregate Discretionary Accruals Return Predictability is Mainly Driven

by Large Firms

Thanks

Presentation Outline

Motivations
Research Questions
Data and Variables
Do Aggregate Discretionary Accruals Predict Stock Market Returns?
What Drives Aggregate Discretionary Accruals Return
Predictability?
Conclusion and Future Research

Our Main Thesis

Total Aggregate accruals

The value-weighted
aggregate accruals
are able to predict
one-year ahead
excess market returns

Value-weighted
Discretionary accruals

Market inefficiency
equity market timing
Hypothesis

The aggregate accruals Value weighted discretionary accruals

return predictability is
driven by valueweighted discretionary
accruals --- which can
be used to measure the
overall level of earnings
management

predict negative returns suggest

market inefficiency

Various evidence favors managerial

equity market timing hypothesis

The value-weighted discretionary

Aggregate normal
accruals, while highly
correlated with
macroeconomic
variables, have no
predictive power

accruals are robust with the inclusion

of other proxies for market timing
abilities

Future Research
Why equal-weighted discretionary accruals do not have any
predicative power?
Further understanding of the properties of value-weighted
discretionary accruals
Cross-country Comparison?
Others

Thanks