ANALYSIS OF THE RELATIONSHIP BETWEEN STOCK MARKET PRICES AND MACROECONOMIC AND FINANCIAL FACTORS: A LINEAR APPROACH

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1 ANALYSIS OF THE RELATIONSHIP BETWEEN STOCK MARKET PRICES AND MACROECONOMIC AND FINANCIAL FACTORS: A LINEAR APPROACH ABSTRACT Andrea Donso, Unversy of Evora, Evora, Porugal Ru Menezes, ISCTE, Lsboa Porugal Dana Mendes, ISCTE, Lsboa, Porugal Jacno Vdgal da Slva, Unversy of Evora, Evora Porugal Ths paper nvesgaes he relaonshp beween he behavour of ceran economc facors and he Poruguese sock marke prces based upon unequaonal and mulequaonal lnear models. Keywords: Sock marke, macroeconomc and fnancal facors, effcen marke hypohess, unequaonal and mulequaonal lnear models. 1. INTRODUCTION I s que common o fnd n he fnancal leraure heores and models based on he effcen marke hypohess, whch mples ha predcon and forecasng based on hsorcal raes of reurn or oher facors are no possble o perform n pracce. Ths argumen has been renforced by emprcal fndngs ha sock prces follow a random walk process, hus renderng hard and almos useless any aemps o oban shor erm forecass. Therefore, an alernave way for sudyng he relaonshp beween he economc acvy represened by macroeconomc facors and he behavour of prces n he sock marke les on he analyss of long-run rends based on monhly observaons (Pesaran and Tmmermann, 1995). The res of he paper s organzed as follows. Secon presens he heorecal framework for accessng he relaonshp beween he behavour of sock markes and varous macroeconomc and fnancal facors. In Secon 3 we descrbe and jusfy he daa used n our analyss and he resuls obaned from mplemenng he mehodologes adoped n our sudy. The fnal secon presens some concludng remarks of hs sudy.. LITATURE REVIEW Asse prces are commonly beleved o reac sensvely o economc news. Furhermore, daly experence seems o suppor he vew ha ndvdual asse prces are nfluenced by a wde varey of unancpaed evens and ha some evens have more persuasve effecs on asse prces han ohers. In hs conex, he porfolo heory, based on he dversfcaon effec, focuses s aenon on he sysemac rsk. The general concluson of ha heory s ha an addonal componen of long-run reurn s needed and obaned whenever a parcular asse s nfluenced by sysemac economc news and here s no possbly o make exra prof n a dversfed porfolo (Ross, 1976). However, he economc heory, lke usually happens n hese crcumsances, says nohng abou he defnon of he evens wh capably o nfluence asse prces. Some sudes show ha here s lle emprcal evdence o suppor he hypohess ha he sock prces respond o macroeconomc news. Schwer (1981) found ha daly response of sock prces o news abou nflaon from 1953 o 1978 s weak and slow. Pearce and Roley (1985) found ha sock prces respond o moneary nformaon bu no o news abou he consumer prce ndex, unemploymen and ndusral producon. In he same conex Chen, Roll and Ross (1986) analyzed he nfluence of nnovaons of some macroeconomc varables and concluded ha he some of hose affec sysemacally asse prces n a sgnfcan way. Oher sudes pon o he exsence of sgnfcan effecs from busness condons on sock prces. Fama and French (1989) and Fama (1990) consder ha he erm-premum and defaul-

2 rsk premum are deermnan varables of equy dscoun raes. Fama and French (1993) denfed fve common facors n he reurns on socks and bonds. McQueen and Roley (1993) have shown ha he effec of real acvy news on proxes for expeced cash-flows and equy dscoun raes s very weak. Pesaran and Tmmermann (1995) found ha he predcve power of varous economc facors over sock reurns changes over me and ends o vary wh he volaly of reurns. Accordng o hese auhors, hs predcably does no mean a break of he effcen marke hypohess, and should be nerpreed as an neremporal equlbrum model. There are alernave approaches ha accoun for he possble bdreconal relaonshps beween sock reurns and macroeconomc varables, revealng n some cases ha s he sock marke ha "leads" he real economc acvy [see e.g. Fama (1981, 1990), Hodrck (199), Bnswanger (000, 001)]. Globally, seems ha here s a se of varables ha may affec sock reurns and can show some feedback effecs. The majory of he sudes n hs feld suppor he possbly of predcably of sock reurns, bu rejecon of he effcen marke hypohess based on hs evdence was no clear for mos of hem. 3. DATA AND RESULTS 3.1. Daa The purpose of hs sudy s o evaluae he behavour of he Poruguese sock marke o changes on a se of economc and fnancal facors seleced accordng o he relevan leraure n hs feld (see e.g. Chen e al. 1986, Asprem 1989, Campbell e al. 1989, Campbell 1991, Hordrck 199, Fama e al. 1993, McQueen e al. 1993, Pesaran e al. 1995, Raj e al. 1995, Maasoum e al. 00). The defnon and source of he ndcaors ha were seleced as well as he defnon of he varables compued on he bass of he seleced ndcaors, are shown n Tables 1 and. (NOTE: The sandard perod s 1 monh, hus, [ 1] E denoes he expecaon operaor a he end of he monh 1 condonal on he nformaon se avalable a he end of he monh 1. X denoes he value of he varable X n monh, or he growh rae ha prevaled from he end of 1 o he end of.) TABLE 1. GLOSSARY AND DEFINITION OF INDICATORS. Indcaor Symbol Fon and defnon PI Lsbor M Fon: Daa base Dhas Prce ndex of he Poruguese sock marke Shor-erm neres res 3 Monhly prce ndex, Fon: Daa base Daasream Long-erm neres rae Dvdend yeld Earnngs prce rao Consumer prce ndex Indusral producon ndex Unemploymen Ol prces Swap 10 Fon: Daa base Dhas DY EPR IPC IPI Fon: INE TD OIL Dvdends/prce rao, Fon: Daa base Daasream Earnngs/prce rao, Fon: Daa base Daasream Fon: Daa base Daasream Fon: Daa base Daasream Spo ol prces n he USA marke, Fon: hp:// We defne as he monhly excess reurn; lsbor3m he shor-erm neres growh rae; Swap10 he long-erm neres growh rae; DY he dvdend yeld growh rae; EPR he earnngs prce rao growh rae; IPC he IPC growh rae; PIM he monhly ndusral

3 producon growh rae; PIA he year on year ndusral producon growh rae; TD he unemploymen growh rae and OIL he ol prce growh rae. Accordng o some auhors (e.g. Chen e al. 1986, Fama 1990, and McQueen e al. 1993) we should use he unancpaed changes n he varables, or he respecve nnovaons. Because some of he me seres have evdence of sgnfcan auocorrelaon and seasonaly, was necessary o fler he seres, as shown n Table. TABLE. FILTED SIES THAT REPRESENT THE UNANTECIPATED CHANGES IN THE VARIABLES New varable novlsbor ARMA( ) novswap ARMA( ) novipc ( ) novpim ( ) novpia ARMA( ) novtd ARMA( ) 1, 0 of Lsbor3M 1, 0 of Swap10 Process ARMA 3,1 of IPCSA, IPCSA s he seasonal effec adjusmen of IPC ARMA, 0 of IPMSA, IPMSA s he seasonal effec adjusmen of PIM 1,1 of PIA 1,1 of TD The seasonal adjusmen was made hrough a movng average process. 3.. Unequaonal lnear models When analyzng he mpac of macroeconomc and fnancal varables on he excess reurn n sock markes, he economc and fnancal heory does no usually provde grea gudance n wha refers o he denfcaon of he number of lags o consder n he explanaory varables of he models. In emprcal works, for example, Chen, Roll and Ross (1986) dd no use any lags of he explanaory varables n her lnear regresson models. Jones and Kaul (1996) argued ha f he markes are effcen hen only he conemporaneous varables should be sascally sgnfcan, decreasng s explanaory power when he lag lengh ncreases. On he oher hand, Pesaran and Tmmermann (1995) consder ha he explanaory varables should no be conemporaneous wh he ndependen varable, because s mporan o ake no accoun he effecs of economc cycles. These auhors sugges he use of one or wo lags when we are usng monhly daa. Fama (1981, 1990) on he oher hand, argued ha he sock marke, and parcularly he measure of excess reurn, s he one ha leads he real economc acvy (n he presen paper: novpim and novpia ) and hus one should use leads and lags when modellng he economc and fnancal effecs on he sock marke. In order o selec he sgnfcan lags of he explanaory varables, we analyzed he sascal sgnfcance of he explanaory varable coeffcens, for dfferen lags. The resuls obaned allow us o denfy he followng sgnfcan explanaory varables for : novswap, DY, EPR, EPR 1, novipc 3, novpim, novtd, novtd 3 and OIL. (NOTE: A number of sascal ess on he resdual of he esmaed models were performed. The resuls show he exsence of auocorrelaon on he bass of he Durbn-Wason and Ljung- Box ess, for he mos of he models esmaed. The null hypohess of sably of he resduals was no rejeced accordng o he CUSUM and CUSUM_Q ess. The resuls of he Jarque-Bera es show ha only he resduals resulng from he esmaon of he regresson = α + β EPR + ε have sgns of non-normaly. From he resuls of he ARCH LM ess, we found ha he vas majory of he resduals show evdence of heeroscedascy.) The coeffcens ha are sascally sgnfcan n our conex reveal how he Poruguese sock marke excess reurn reacs o shocks n he explanaory varables. In general, our resuls are conssen wh he resuls repored n oher sudes [e.g. Fama (1981), Geske e al. (1983), Chen e al. (1986), Lee (199), Pesaran e al. (1995), Jones e al. (1996), Bnswanger (000)].

4 The varable DY shows conemporaneous negave sgnfcan mpac on he excess reurn. However hese resuls are no drecly comparable wh hose obaned by oher auhors [e.g. Hordrck (199), Campbell e al. (1989), Pesaran e al. (1995), Raj e al. (1995)]. Ther resuls presen a posve sgnfcan mpac of DY on he excess reurn. Therefore, wo possble explanaons for our resuls le on he consrucon of he varable DY self and/or n he behavour of n he varable DY self, because DY s no saonary. In hs conex Fama (1990), for example, argues ha once shocks n DY are lead by he sock prces, hen conemporaneous shocks n DY are necessarly negavely correlaed wh he excess reurn. Havng analyzed he sngle relaonshp beween he macroeconomc and fnancal varables wh he excess reurn, varable by varable, s now mporan o assess he overall performance of he relaonshp n order o verfy wheher he se of regressors keep s explanaory power when aken all ogeher. To hs end we have esmaed a mulvarae lnear regresson model [equaon 1] by OLS and he resuls are shown n Table 3. (NOTE: ** refers o 1% sgnfcan level and * refers o 5% sgnfcan level.) = α + β novswap + β DY + β EPR β EPR + β novipc β novpim + β novtd + β novtd + β OIL + ε (1) TABLE 3. RESULTS OF THE LINEAR REGRESSION MODEL (EQ. 1) Varable (1) β () ( β ) (3) Varable (4) β (5) ( β ) (6) α α DY ** DY ** EPR ** EPR ** EPR ** EPR 1 1 novipc * novswap novpim novtd novtd OIL ** novipc * R R R adjus R adjus SIC SIC AIC AIC F-sascs ** F-sascs ** These varables were seleced accordng o he resuls presened n he prevous analyss based on unvarae lnear regresson. Columns (4), (5) and (6) refer o he lnear regresson model where he ndependen varables are hose ha exhb sascal sgnfcance n he global model. We made several sascal ess on he resduals of he model, namely he LM es, he ARCH LM es, he Jarque-Bera es and he sably ess CUSUM and CUSUM_Q. The resuls of hese ess only perm o rejec he null hypohess of he Jarque-Bera sasc, hus, he resduals are no normally dsrbued.

5 The resuls presened n Table 3 demonsrae ha he only sgnfcan explanaory varables ha are reaned by he mulvarae model are: DY, EPR EPR novipc. Ths may be he, 1, -3 effec of he remanng non-sgnfcan varables can be capured by he reaned varables due o problems of mulcollneary. Thus, we may say ha only hese four varables consue proxes for he Poruguese sock marke excess reurn on he bass of he seleced orgnal ndcaors. Our resuls are n accordance wh he resuls repored by oher auhors, namely ner ala Fama (1981, 1990), Fama and French (1993), and Maasoum and Racne (00) Mulequaonal lnear models In he las subsecon we used unequaonal lnear models where he excess reurn was he only dependen varable. However seems que reasonable o assume ha here may exs some feedback effecs beween he sock marke and he macroeconomc and fnancal varables. Accordng o Chen, Roll and Ross (1986), Fama (1990) and Chen (1991), among ohers, we mus analyse he nfluence of he sock marke behavour on he economy and respecve facors. One way o perform such analyss s o use a VAR model (Vecor Auoregressve Model). If X s a vecor of saonary varables and A s a marx of coeffcens, hen he VAR model can be descrbed by X = AX A X + ε () 1 1 p p In order o selec he number of lags o consder n he VAR model we can use he Akake Informaon Creron (AIC) or he Schwarz Informaon Creron (SIC). Besdes evaluang he relaonshps beween he varables, akng no accoun he feedback effecs, s sll mporan o analyze he causaly ha may exs beween he varables. In hs conex we used he Granger causaly es, whose basc dea s he fac ha he cause canno happen afer he effec ha s he fuure canno cause he presen. The use of VAR models can be an approprae approach o analyze he recprocy n he relaonshps beween saonary varables. The use of hese models and he percepon of her advanages have been explored n he fnancal leraure. For nsance, James, Koresha and Parch (1985) appled a VARMA model wh 4 varables: he rae of reurn of he sock ndex S&P 500, he real acvy ndex, he nflaon rae and he money supply growh. These auhors conclude ha here exs mporan causaly relaonshps beween hose varables. Several auhors appled VAR o analyse he relaonshp beween he rae of reurns and some macroeconomc and fnancal varables, namely Campbell and Shller (1989), Hodrck (199) and Lee (199). In hs paper we analyse he causaly relaonshps beween he economc varables and he excess reurn. Frsly we performed he parwse Granger causaly ess of each varable wh he excess reurn. The null of no causaly s rejeced n all cases. The resuls obaned wh he Granger causaly es appear o be n agreemen wh he resuls obaned by several auhors (e.g. Lee 199, Bnswanger 000), revealng ha he sock marke ancpaes and affecs he real acvy. The esmaon of he VAR models for each par of varables pons o smlar resuls o hose obaned n he las subsecon wh he unequaonal models. In he Table 4 we presen he relaonshps ha show sascal evdence. (NOTE: The values n brackes refer o he sandard-devaon. The number of lags was seleced accordng o he AIC creron. * * refers o 1% sgnfcan level and * refers o 5% sgnfcan level.)

6 TABLE 4. RESULTS OF THE ESTIMATED VAR MODELS novipc novpim novtd 0.3* * * (0.096) (0.004) 1 (0.093) (0.106) 1 (0.096) (0.03) (0.099) (0.004) (0.09) (0.105) (0.098) (0.04) ** novpim (0.097) (0.004) 1 (0.085) (0.097) 3 (0.098) (0.04) ** novipc 1 novpim (.61) (0.095) novtd (0.094) (0.106) 1 (0.395) (0.096) novipc C novtd (.56) (0.095) (0.005) (0.006) (0.404) (0.099) * novipc 3 novtd (.35) (0.094) 3 (0.401) (0.098) C C (0.005) (0.00) (0.005) (0.001) R R R R adjus R adjus R adjus AIC AIC AIC SIC SIC SIC E[ ε, ε ] 1.65E-08 E[ ε, ε ] 1.15E-05 [, ] j j E ε ε 5.5E-07 AIC AIC AIC SIC SIC SIC The resuls presened n Table 4 ndcae ha here s a causaly relaonshp beween and novipc, and he sgnfcan coeffcens are negave. Such resul mplcaes ha he Poruguese sock marke s negavely nfluenced by non-ancpaed changes n nflaon and ha changes shocks n nflaon also receves nfluence from he sock marke. Fama (1981) found a negave correlaon beween he excess reurn and he nflaon, concludng ha hs relaonshp consues a proxy for he posve correlaon beween he excess reurn real economc acvy. However, Lee (199) dd no fnd sgnfcan evdence ha he rae of reurns of he value-weghed ndex of NYSE has nfluence on he nflaon. We mus hghlgh he causaly relaonshp beween andnovpim, where he second lag of he varable novpim affecs n a sgnfcan way, corroborang he resuls obaned n he prevous subsecon. Fnally, s verfed ha he varable novtd also affecs. In order o evaluae he nfluence of he economc varables n a more general way, we compued a VAR(3) model whch resuls show ha he varables novipc and OIL can be consdered exogenous n a sascally sgnfcan way, snce he equaons n he VAR for hs varables do no conan any sascally sgnfcan coeffcen. We mus hghlgh he fac ha he equaon for obaned wh he VAR does no dffer very much from equaon (1), descrbed n he las subsecon. The resuls obaned seem o ndcae ha ancpaes he shocks n neres raes n he shor-run, n agreemen wh he effcen marke hypohess, here he sock markes show a srong reacon o he announcemen of evens and no so much facng o evens hemselves. On he bass of he resuls obaned wh he hree VAR models, we can say ha he varable s nfluenced and also has an nfluence on oher varables, namely DY andnovipc. The resuls obaned do no allow us o conclude ha he Poruguese sock marke ancpaes and nfluences he real economc acvy ( novpim and novpia ) n he shor-run. I s mporan o noe ha he VAR(3) esmaed, corroborae hose obaned wh he unequaonal lnear models. The resuls obaned sll ndcae a complexy of he economc sysem, beng denoed ha he sock marke s a consequence bu also a cause of a group of varables, exsng a srong connecon beween he varables. j

7 4. CONCLUDING REMARKS Fnancal leraure suggess ha sock marke reurns are drven by fnancal frm-specfc facors and are nfluenced by many macroeconomc varables. The man goal of hs paper s o deermne he relaonshp beween he Poruguese sock marke and a se of macroeconomc and fnancal facors ha were chosen accordng o he relevan leraure n hs feld. Such relaonshp was suded usng unequaonal and mulequaonal lnear approaches, focusng manly on he shor-erm componen of he marke. Globally, our resuls ndcae ha some explanaory varables appear o have a sascally sgnfcan nfluence on he excess reurn and hus may consue good proxes for hs varable. The fnancal frm-specfc facors varables showed a hgher nfluence on he excess reurn han he macroeconomc varables under sudy. The varables DY and EPR presen sascal sgnfcance and consue good proxes for he excess reurn, alhough her coeffcens are negave whch some how conradcs he heory. Anoher mporan remark s he fac ha he Poruguese sock marke excess reurn s no exclusvely an exogenous varable, snce also has an nfluence on some oher varables. REFENCES Asprem, M. Sock Prces, Asse Porfolos and Macroeconomc Varables n Ten European Counres. Journal of Bankng and Fnance, 13, 1989, Bnswanger, M. Sock Marke Booms and Real Acvy: Is Ths Tme Dfferen?. Inernaonal Revew of Economcs and Fnance, 9, 000, Bnswanger, M. Does he Sock Marke Sll Lead Real Acvy? - An Invesgaon for he -7 Counres. Seres A: Dscusson Paper , Solohurn Unversy of Appled Scences Norhwesern, Swzerland, 001. Campbell, J. A Varance Decomposon for Sock Reurns, Economc Journal, 101, 1991, Campbell, J. and Shller, R. The Dvdend-Prce Rao and Expecaons of Fuures Dvdends and Dscoun Facors. Revew of Fnancal Sudes, 1, 3, 1989, Chen, N-F., Roll, R. and Ross, S. Economc Forces and he Sock Marke. Journal of Busness, 59, 3, July, 1986, Fama, E. Sock Reurns, Real Acvy, Inflaon and Money. Amercan Economc Revew, 71, 1981, Fama, E. Sock Reurns, Expeced Reurns and Real Acvy. Journal of Fnance, 45, 1990, Fama, E. and French, K. Busness Condons and Expeced Reurns on Socks and Bonds. Journal of Fnancal Economcs, 5, 1989, Fama, E. and French, K. The Cross-Secon of Expeced Sock Reurns. Journal of Fnance, 47, 199, Fama, E. and French, K. Common Rsk Facors n he Reurns on Bonds and Socks. Journal of Fnancal Economcs, 33, 1993, Geske, R. and Roll, R. The Fscal and Moneary Lnkage beween Sock Reurns and Inflaon. Journal of Fnance, 38, 1, 1983, Hodrck, R. Dvdend Yelds and Expeced Sock Reurns: Alernave Procedures for Inference and Measuremen. Revew of Fnancal Sudes, 5, 3, 199, Jones, C. and Kaul, G. Ol and Sock Markes. Journal of Fnance, 51, 1996, Lee, B-S. Casual Relaons Among Sock Reurns, Ineres Raes, Real Acvy, and Inflaon. Journal of Fnance, 47, 4, 199, Maasoum, E. and Racne, J. Enropy and Predcably of Sock Marke Reurns. Journal of Economercs, 107, 00, McQueen, G. and Roley, V. Sock Prces, News and Busness Condons. Revew of Fnancal Sudes, 6, 3, 1993, Pearce, D. and Roley V. Sock Prces and Economc News. Journal of Busness, 58, 1985, Pesaran, M. and Tmmermann, A. Predcably of Sock Reurns: Robusness and Economc Sgnfcance. Journal of Fnance, 50, 1995, Raj, M. and Thurson, D. Predcve Ably of Earnngs and Dvdend Yelds: An Emprcal Evaluaon of New Zealand Socks. Appled Fnancal Economcs, 5, 1995,

8 Ross, S. The Arbrage Theory of Capal Asse Prcng. Journal of Economc Theory, 13, 3, December, 1976, Schwer, G. W. The Adjusmen of Sock Prces o Informaon abou Inflaon. Journal of Fnance, 36, 1981, Auhors proflles Andrea Donso s a PhD suden a ISCTE Lsbon, Porugal. Currenly s a professor of quanave mehods on he Unversy of Evora, Managemen Deparmen, Largo Colegas,, 7000 Evora, Porugal, Emal: andrea@uevora.p. Ru Menezes earned hs PhD a he Unversy of Keele, U.K. Currenly s a professor of quanave mehods on ISCTE, Quanave Mehods Deparmen., Av. Forcas Armadas, Lsboa, Porugal, Emal: ru.menezes@sce.p Dana Mendes earned hs PhD a he UTL, Porugal. Currenly s a professor of quanave mehods on ISCTE, Quanave Mehods Deparmen., Av. Forcas Armadas, Lsboa, Porugal, Emal: dana.mendes@sce.p Jacno Vdgal da Slva earned hs PhD a he Unversy of Evora, Porugal. Currenly s a professor of fnance on he Unversy of Evora, Managemen Deparmen, Largo Colegas,, 7000 Evora, Porugal, Emal: jslva@uevora.p. NOTE: Ths paper s a shor-verson of an exended paper whch ncludes a nonlnear analyss of he nfluence of he macroeconomc and fnancal varables on he Poruguese sock marke.