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Macroeconomic Variables and Stock Market Indices

Introduction and Background The financial system is considered to be the key to economic growth. A well developed and sound financial system promotes investment by the identification and financing of profitable business opportunities, through the inflammation of savings, the efficient allocation of resources, by helping to diversify risks and by facilitating the exchange of goods and services. (Manikins, 2001).

As such, stock markets have assumed a developmental role in international economics and finance following the impact they have exerted on economic activity. Stock markets are known not only as the foundations of a modern, market based economic system but they also act as channels for the movement of long term financial resources from the savers of capital to the borrowers of capital. Therefore, efficient capital markets have an instrumental role to play in economic growth and prosperity.

Fame, who is often quoted as the father of the efficient market hypothesis has described an efficient market as one in which security prices adjust rapidly to the arrival of new information and therefore, the current prices of securities reflect all information about the security. In simpler terms, this means that no investor should be able to employ readily available information to be able to

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predict movements in stock prices quickly enough in order to make profit through trading of shares. Thus, the efficient market hypothesis requires stock prices to contain all relevant information. .

Professional Significance and Rationale

This study is important for several reasons. The MME (Efficient Market Hypothesis), in particular the semi strong from efficiency is considered to be of paramount importance for economists, policy makers and investors alike. The semi strong form f MME asserts that all publicly available information for example accounting data in a company’s annual report such as earnings announcements and dividend increase announcements should be reflected in stock prices.

Information inefficiency in stock market hence implies that market participants are able to develop profitable trading rules and can thereby consistently earn more than average returns, and on the other hand the stock market is not likely to play an effective role in channeling financial resources to the most productive sectors of the economy. While finding causality from lagged values of stock prices to an economic aggregate goes not violate informational efficiency, this finding is equivalent to the existence of causality from current values of stock prices to future economic variable.

This would suggest that stock prices lead the economic variable and that the stock market makes rational forecasts of the real sector. If stock prices accurately reflect the underlying fundamentals, then the stock prices should be employed as leading indicators of future economic activity, and not the way around. Policy makers should thus feel free

Macroeconomic Variables and Stock Market Indices

By enthusiasts formation and the stock trade process.

Therefore, the causal relations and dynamic interactions among the macroeconomic variables and stock prices are important in the formulation of a nation’s macroeconomic policy Money supply and interest rate are macroeconomic variables which have an effect on stock prices. As far as they are concerned, the MME has suggested that in an efficient market competition between profit maximizing investors will make sure that the current stock prices reflect all the information which are currently known regarding the changes in macroeconomic variables.

Thus, investors will not be able to take advantage and earn abnormal refits by predicting the future stock market movements. (Chon and Koch, 2003). Therefore, if one were to believe the conclusions drawn by the MME, investment advisors would not be able to help investors earn above average returns consistently, except through access to and employing insider information, a practice which is generally prohibited and punishable by law; there would furthermore be no stock broking industry.

In contradiction to the conclusions drawn by the MME, evidence that key macroeconomic variables help predict the time series of stock returns has accumulated for nearly 35 years. Professional Significance and Rationale The study is important for the several reasons. First, stock synchronicity is measured for emerging markets and compared with the developed economies. Roll (1988) argues that stock synchronicity can push the value of a stock from its fundamental value and this over- or under-valuation of stocks can adversely affect the overall equity market. Further, Campbell et al. 2001) argue that large investors are exposed to greater risk as stock synchronicity increases. Indeed, stock synchronicity is an important factor for developed market economies as well as for the emerging market economies More info on significance to whom? This might be highly relevant, for example, to private investors, pension funds and governments, as many long term investors base their investment in equities on the assumption that corporate cash flows should grow in line with the economy, given either a constant or slowly moving discount rate. Thus, the expected return on equities may be linked to future economic performance.

An understanding of the macro dynamics of Indian stock market can be valuable for traders, investors and also for the policy makers of the country. Results of the study may help in diagnosing whether the movement of stock market is the result of some other variables or it is one of the causes of movement in other macro variable in the economy. The study also expects to explore whether the movement of stock market is associated with the economy. If stock prices accurately reflect the underlying fundamentals, then the stock prices should be employed as leading indicators of future economic activities.

Therefore, the causal relations among macroeconomic variables and stock prices are important in the formulation of the nation’s macroeconomic policy.

Literature Review: The relationship between macroeconomic variables and stock .

Macroeconomic Variables

Macroeconomic variables are defined as variables that affect the economy as a whole. They are considered as the main indicators or main signposts indicating current trends in an economy. Examples of macroeconomic variables include inflation, Gross Domestic Product (GAP), unemployment, economic growth, investment amongst others.

The National Bureau of Economic Research offers a classification of macroeconomic variables according to the timing on how the latter changes relative to the changes of the economy as a whole. (Siskin, Moore, 1968)

* Leading agronomic variables, these are indicators that change before the economy changes. For example stock market returns are considered to be leading indicators. They usually start to decline before an economy declines and they pick up before the economy starts to pull out of a recession. Lagged macroeconomic variables, these are variables that do not change their trend until a few quarters after the economy does. An example is the unemployment rate which tends to increase for 2 or 3 quarters after the economy starts to pick up.

* Coincident macroeconomic variables, these are the variables that move at the rate time as the economy. An example is the Gross Domestic Product.

Stock Market Indices

According to the Securities Exchange Commission (SEC), a market index indicates the performance of a specific “basket” of stocks believed to represent a particular market or sector of a market or an economy.

There are actually indices representing every conceivable sector of an economy and stock market. Examples of stock market indices are the DOD Jones Industrial Average (DEJA) which indicates the performance of the 30 “blue chip” companies in the U. S. An example of an Australian stock index is the S;P/ASS 20. The relationship between stock prices and stock market indices is worth discussed. There is a direct relationship that is when the stock market price goes up, the stock market index increases and when the stock market index goes up, the stock price increases as well.

As such, stock market index and stock market prices are used interchangeably in this research.

Empirical Evidence

In the past decades, many financial analysts, industry practitioners and researchers have tried to forecast the relationship between macroeconomic variables and stock markets indices. As such, many empirical studies have been conducted to study the allegations between these two. The results of all the previous studies have concluded different outcomes according to the mixture of variables, methodologies and analysis performed.

Researchers have found out that 30-35% of changes in stock price can be attributed to economy-wide factors (Chancre, 2004). It can be argued that company earnings, which themselves depend on stock price determination rely on variables such as economic growth, output growth and prosperity, the availability of quality labor force and the capital stock (Glob and Bishop 1997). There are however other factors which directly or indirectly bear on economic growth and prosperity, and thus influences the behavior of stock prices. (Skinhead, 2002). Mays et al. 2004) identified short and long term interest rates, industrial production, price levels, exchange rate and money supply using co consists of Bullish and Tripoli (1991), Billions et al (1999), Honoraries ad Patterson (2001), Panacea (2002), Mien and Casein (2003), Islam (2003), Aberrant et al. (2004) and Gag and Conman (2006). From the above, it suggests that there are some key variables that are used to depict the condition of the macro economy that an investor must observe and predict. The significance is to have an idea of the potential company earnings and the payment of dividends and interest.

Related article: The Stock Market Is Worried About Inflation. Should It Be?

The key variables comprise: Industrial Growth Rate, Gross Domestic Product (GAP), Capacity utilization, Price Level and Inflation, Balance of Payments, Savings and Investment, Exchange Rates, Money Supply, Foreign Exchange Reserves and Interest Rates. Many researchers have established empirical evidence linking selected macroeconomic variables to market indices.

Interest Rate and Stock Prices

Interest rate varies with time, default risk, inflation rate and productivity of capital amongst others. Chancre, 2004). Interest rate changes promote substitution between money market instruments, stock market and speculative activities.

According to Kevin (2006), interest rates in an organized financial sector of an economy are channeled within favored range through the nation’s monetary policy. In contrast, for an unrecognized financial system, the rates are not managed causing it to fluctuate extensively depending on the demand and supply conditions of funds in the market. An investor should consider the level and increase in interest rates existing in the various segment of an economy and should assess their impact on the reference and profitability of companies.

According to Chancre (2004), an increase in interest rate will depress company profits and will also lead to a rise in the discount rate which is applied to equity investors, both having a negative effect on stock prices and vice versa. Thus, an increase in interest rate is anticipated to impact adversely on the performance on a company. In support of this is the evidence from the United States of stock prices Jumping sometimes before and after The Federal Reserve announcing a cut in the interest rate or discount rate, or Chase Manhattan announcing a cut in its prime loan rate. Smith, 1990).

Also, Swami and Jung (1997), in their study on the Korean economy establishes a negative relationship with long term interest rate and stock prices and a positive association with stock indices and short term interest rates.

Inflation and Stock Prices

Inflation has a positive and negative effect on some sectors. While some industries suffer from an increase in the general price level, others benefit from this increase. (Chancre, 2004). Particularly, Fame and Chewer (1977) show that stock indices are inversely related to both the expected and unexpected component of Consumer Price Index.

Money Supply and Stock Prices

Many studies have been conducted to analyses the effect of money supply on the stock markets, but with varying results. Empirical investigations of the relationship between share price and money supply in a study carried out by Sprinkle (1964) established a strong correlation between the two variables in the USA. Other studies dealing with the association between these two variables for example, Mays, Koch (2000), disclosed a positive relationship between money supply and the SEX index (Singapore stock exchange) in the Asian market, confirming the results concluded by

Fame (1981). The association between money supply and share prices on Asian association between money supply and share prices. Studies from the sass also showed direct association between share prices and money supply over the short run. However, this is challenged by Banging (2004) who concluded a negative relationship between the SEES index and money supply over the period from 2001 to 2003. However, over the longer run from 1993 to 2001, the author concluded that synchronous changes took place in the development of the Chinese SSE index and changes to the supply of money in the economy.

Kraft, Kraft (1977) however, could not establish any causal association between money supply and share prices. In addition, Latino and Fazed (2008) concluded that there is no long term relationship between share prices and money supply. 2. 2. 4 Exchange Rate and Stock Prices The debate concerning the relationship between exchange rates and stock prices started few decades ago. Contradictory results concerning the relationship between exchange rate and the direction of that relationship have been made. Some studies concluded significant positive relationship such as Gradual (1981), Giovanni and

Jargon (1987) and Roll (1992). However, some of the studies contradict this argument and showed significant indirect relationship between the variables such as Someone and Hennaing (1988). Some other researches also conclude no association between these variables, for example, Franca and Young (1972), Solons (1987), Chow et al. (1997) and Apothecary and Musketeer (2003). 2. 2. 5 Oil Price and Stock Prices Over the past 30 years, oil prices have got key attention as an economic indicator. A thorough macroeconomic literature indicates strong association between oil prices ND economic output.

Authors argue that oil price has an indirect effect and it is fed through the macroeconomic variables. An increase in oil price is expected to have a positive effect in oil exporting countries. (Absorbing, 2009; Jimenez Rodriguez and Sanchez 2005). It is believed that income will rise causing an increase in expenditure and investments, which will in turn creates greater productivity and high employment. Stock markets have the tendency to respond in a positive manner to such events. For countries importing oil, any increase in the price of oil will have the opposite effect (Labeled and Chino, 2004; Hooker, 2002).

Oil price increases lead to increase in cost of production as oil is one of the most important factor of production. (Aurora and Unguent 2010; Backs and Crucial, 2000; Kim and Lounging, 1992). This increase will be passed to consumer, which in turn will lead to decreasing demand and therefore consumer spending. (Brenan, 2006; Able and Brenan, 2001 ; Hamilton, 1996; Hamilton, AAA, Bibb and Barron, 1984). Lower consumption might lead to decreasing production and thus increasing unemployment (Lardier and Mignon, 2006; Brown and Yucca, 2002; ad Davis and Haltering, 2001).

Stock markets would thus react negatively in these cases. (Skyward, 1999; Jones and Gaul, 1996). We should however note that oil price shocks can have an impact on markets due to the uncertainty that they create to the financial world, depending on the nature of the shock (supply side or demand side). Markets would react positively with demand side shocks and negatively with supply side shocks. 3. 0 Research Gap [ 1 ]. A search in the Wall Street Journal from 1983 to 2013 yields 11930 articles; more than one article per day

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