Accruals correlate closely with the determinants of the conditional equity premium at both the firm and the aggregate levels. The common component of firm‐level accruals, which cannot be diversified away by aggregation, explains the positive relation between aggregate accruals and future stock market returns. The residual component, which accounts for most variation in firm‐level accruals, is responsible for the negative cross‐sectional relation between firm‐level accruals and future stock returns. Consistent with the risk‐based explanation, aggregate accruals, as a proxy for the conditional equity premium, forecast changes in aggregate economic activity. Moreover, we document a similar comovement of earnings with the conditional equity premium at both the firm and the aggregate levels, which helps explain the negative relation between changes in aggregate earnings and contemporaneous market returns.

The aggregate default probability is significantly priced in equities because of its close relation with uncertainty. Ceteris paribus, the aggregate default probability positively predicts stock market returns, and loadings on its changes correlate negatively with the cross-section of expected stock returns. These findings are consistent with multifactor models in which aggregate uncertainty is a determinant of the conditional equity premium and innovations in aggregate uncertainty are a systematic risk factor. By contrast, credit spreads have negligible explanatory power for expected stock returns. Contrary to the conventional wisdom, credit spreads are poor proxies for aggregate credit risk.