On the Effects of Prices leading Earnings Phenomenon on Return Models

It is well known that when prices lead earnings, Earnings Response Coefficients (ERC) from Return models (price changes regressed on earnings changes) are biased towards zero (Kothari and Zimmerman, 1995). This paper provides a framework of modeling the effects of the above phenomenon while controlling for the thorny problems of Cross-Sectional Dependence (Bernard, 1987) and cross-sectional variation of the coefficients (defined as Heterogeneity, Teets and Wasley, 1996). Through the use of both heterogeneous and homogeneous panel estimators, which increase the power of the tests, we show that our research framework produces estimates of the ERC that are closer to that implied by the theory than the simple return model. Moreover, we find evidence of cross-sectional dependence and heterogeneity and we provide means of controlling for it. However, our results are far from the plausible values which may be due to the presence of transitory components or non-linearities in earnings and requires further research. Moreover, even though tests of Cross-Sectional Dependence indicate its presence in our data its effects on the results are not visible.