Suresh Nallareddy

Predicting Restatements in Macroeconomic Indicators Using Accounting Information

Earnings growth dispersion contains information about trends in labor reallocation, unemployment change, and, ultimately, aggregate output. We find that initial macroeconomic estimates released by government statistical agencies do not fully incorporate this information. As a consequence, earnings growth dispersion predicts future restatements in nominal and real GDP growth (and unemployment change) both in the in-sample and out-of-sample tests. The documented predictable restatements are not fully anticipated by the investors. Further, when we adjust GDP estimates using the out-of-sample restatement predictions, we find statistically and economically significant effects for the monetary policy prescriptions (Taylor rule) and banking regulation (Basel III).

Accrual Quality, Skill, and the Cross-Section of Mutual Fund Returns

We use returns of actively managed mutual funds to document the link between accrual quality (AQ) and systematic (priced) risk. Despite compelling theoretical arguments, prior research finds no evidence that poor AQ commands a risk premium in the cross-section of realized stock returns. We argue that the previously obtained premium estimates are biased downward because, for a large portion of poor AQ stocks, higher expected returns are offset by the news of deteriorating fundamentals. We suggest that skilled mutual fund managers should be able to either avoid investing in stocks with deteriorating fundamentals or assign them lower portfolio weights. As a consequence, returns on their portfolios should better reflect the expected AQ risk premium. Our empirical evidence is consistent with these predictions.

Uncertainty and Sectoral Shifts: The Interaction Between Firm-Level and Aggregate-Level Shocks, and Macroeconomic Activity

This study predicts and finds that the interaction of firm-level and aggregate-level shocks explains a significant portion of shocks to macroeconomic activity. Specifically, we hypothesize that the relation between uncertainty and economic growth is most pronounced when both firm-level and aggregate-level uncertainty are high simultaneously. Similarly, we hypothesize that aggregate performance affects unemployment most when both firm-level dispersion is high and aggregate performance is low, based on the sectoral shift theory. Our hypotheses and empirical results show that the interactive effect of firm-level and aggregate-level shocks are larger than the sum of the individual effects. This paper was accepted by Mary Barth, accounting.

Firms’ Response to Macroeconomic Estimation Errors

Initial Gross Domestic Product (GDP) announcements are important economic signals that convey information on the state of the economy but contain substantial estimation error. We investigate how GDP estimation errors affect firms’ real decisions and profitability. Consistent with theoretical predictions from the literature on macroeconomic signal errors, we find that GDP estimation errors are positively associated with one-quarter-ahead changes in firms’ capital investments, production, inventory, and profitability. Stronger profitability responses to GDP signal errors are observed for firms that are more sensitive to macroeconomic fluctuations. We also observe a reversal in future quarters’ corporate profits, consistent with initial over (under) production being met with declines (increases) in future profitability.

The Changing Landscape of Accrual Accounting: Implications for Operating Cash Flow Predictability

We reexamine the relative ability of earnings and cash flows in predicting future cash flows to achieve two objectives: (i) reconcile the mixed evidence in the prior literature, and (ii) investigate the implications of temporal shifts in accrual accounting for trends in cash flow predictability. Three key insights emerge from our analyses. First, contrary to conventional wisdom, we find that cash flows are superior to earnings in predicting future cash flows. After evaluating several alternative explanations, we attribute the mixed evidence in prior research mainly to measurement errors induced by the balance sheet method of estimating cash flows. Second, we find that earnings’ ability to predict future cash flows is increasing over the period 1989-2015. However, this trend is attributable to the increasing predictive ability of cash flows rather than accruals. That is, while cash flows show an increasing ability to predict future cash flows over time, accruals display no such trend. Our findings are robust to US and international settings. Finally, we document that the increasing predictive ability of cash flows is associated with shortening operating cycles, decreasing working capital accruals, and increasing intensity of intangibles over time.

Macroeconomic Activity Under Uncertainty: How Firm-Level and Aggregate-Level Uncertainties Interact

This study predicts and finds that the interaction of firm-level and aggregate-level shocks explains a significant portion of shocks to macroeconomic activity. Specifically, we hypothesize that the relation between uncertainty and economic growth is most pronounced when both firm-level and aggregate level uncertainty are high simultaneously. Similarly, we hypothesize that aggregate performance affects unemployment most when both firm-level dispersion is high and aggregate performance is low, based on the sectoral shift theory. Our hypotheses and empirical results show that the interactive effect of firm-level and aggregate-level shocks are larger than the sum of the individual effects.

ETF Activity and Informational Efficiency of Underlying Securities

This paper investigates the effect of exchange-traded funds’ (ETF) activity on the short-run informational efficiency of their underlying securities. We find that ETF activity increases short-run informational efficiency for stocks with weak information environments. The increase in informational efficiency results from the timely incorporation of systematic earnings information. In contrast, we find no such effect for stocks with stronger information environments. ETF activity increases return co-movement, and this increase is partly attributable to the timely incorporation of systematic earnings information. Further, ETF activity is associated with an attenuation of post-earnings-announcement drift and an increase in active share lending.

The Role of Taxes in the Disconnect Between Corporate Performance and Economic Growth

We investigate the relation between the growth in corporate profits and the overall U.S. economy, focusing on the impact of the U.S. corporate tax regime on this relation. We document that the growth of corporate profits, on average, has outpaced the growth of the economy and this disconnect increases as the difference between the corporate income tax rate of the U.S. and the other OECD countries increases. The underlying mechanism is fewer corporate profits being channeled into subsequent domestic investments when the U.S. tax rate is relatively higher, leading to lower economic growth. Our findings have implications for policy setters.

Does Differential Sensitivity to Aggregate Earnings Shocks Drive Post-Earnings-Announcement Drift?

This paper finds that returns to the post-earnings-announcement drift (PEAD) strategy result from differential sensitivity of individual stock returns to aggregate earnings shocks. Larger negative aggregate earnings shocks are associated with higher PEAD returns, because stocks in the PEAD’s sell portfolio are more sensitive to aggregate earnings shocks than those in the buy portfolio. Such differential sensitivity to aggregate earnings shocks drives a significant portion of PEAD returns. During the 1985 to 2009 sample period, investors were on average negatively surprised by aggregate earnings shocks, leading to average positive returns to the PEAD strategy. Further analysis suggests that macroeconomic shocks (that work through aggregate earnings shocks) explain the variation in PEAD returns.