Conditional Earnings Dispersion, the Macroeconomy and Aggregate Stock Returns

Prior studies document a robust relation between the equity premium and cross-sectional dispersion in firm-level earnings changes (earnings dispersion). We hypothesize that this relation is driven by an underlying relation between earnings dispersion and the macroeconomy (in particular, unemployment and industrial production). We further hypothesize that the relation between earnings dispersion and the macroeconomy is conditional on the state of the economy. Specifically, the adverse effects of earnings dispersion on the macroeconomy are exacerbated during periods of low aggregate earnings growth. Our results show that earnings dispersion and conditional dispersion relate to unemployment and industrial production as well as aggregate stock returns. Furthermore, we show that conditional dispersion predicts the forecast errors of economists who forecast unemployment and industrial production. Our results highlight that dispersion and conditional dispersion have separate, additive, relations with the macroeconomy.