The causality relationship between Sectoral Stock Market Indices

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The causality relationship between Sectoral Stock Market Indices (plus stock market indices) and the US Economy represented by (GDP, inflation, interest rate)

Literature Review

Introduction

The literature review of this research is focused on the key variables the stock returns of S&P 500 index returns and the GDP per capita. To understand the relation in a systematic manner between the two variables, one needs to define the two variables in the first place. A market index or just stock indexes used to measure the performance of a stock market and its particular section. The index can be computed by taking the weighted average of a range of selected stock prices. The index is used by the financial managers & investors to explain the performance of the market and to compare the returns generated by different stocks or investments. It causes several effects in the economy or macroeconomic factors of the country when these markets are fluctuated.
Stock market indices
There are different kinds of stock indexes working around the globe and the stock index selected for this study is Standard & Poor 500 (S&P 500) Index. It is a diverse and large index which is composed of 500 widely traded stocks and most of them belong to US. The epicentre of financial activities is the US and the movements of the US stock markets are considered as a good indicator of the financial performance of the world. The stocks in S&P 500 are reflected based on their market capitalization and hence if the total market value of the stocks in S&P is increased by 10%, the index will increase by 10%. Thus the GDP and other macroeconomic factors such as interest and inflation can also be changed based on the changes in market index.
Gross domestic product
One of the famous indicators of the economic outlook of a country is measured in terms of Gross Domestic Product per Capita (GDP per Capita). It is simple to calculate as the GDP of an economy is divided by the aggregate population to calculate it. The standard of living of a country can be measured easily with the help of GDP per Capita. The GDP per capita also allows drawing a comparison between the prosperity of the countries and that of the sizes of different population. To get necessarily know-how about the GDP per capita, one needs to gather insights regarding the GDP and its components. It also represents the stock market of the country and its performance over the period of time. If the stock market of the country is stable there are the chances that country may calculate higher GDP.
The Gross Domestic Product of a country consists of four components. The first component is the consumer personal expenditures which include expenses incurred on the purchase of goods and services. A country with a large domestic population will show greater consumer personal expenditures. The second component of the GDP is the business investment in the form of changes in inventory (private) and the fixed investments. The state and federal government spending account for the spending of government which is a 3rd component of the Gross Domestic Product (GDP). The last component of the GDP is the net exports which are the difference between exports and imports. Hence, these factors added and then divided by the total population to determine the GDP per capita.
If further literature regarding the index of the stock market is observed, the stock market is a sophisticated place where the shares and stocks are traded. It is central to the development of an economy and it helps to make the economy competitive. The market index helps to perform the structural reforms in the economy and it is converted from a rigid and insecure economy to a flexible economy which can handle the economic shocks. This it represents that the US economy is also influenced by the changes in stock market performance.
Stock and markets
The stock markets can be divided into different types including the money markets and capital markets and their further classifications. Money markets are a place where buyers and sellers each day enter the market with an offer. The money markets work based on a 360-day cycle in the US. In a money market, the financial investment having a maturity of less than one year is traded. The borrowers can obtain short term funds and loans from the money market.
The second major type of the stock market is the capital market and it is a place of financial instruments having long term maturity is traded. The period of trade of these securities is more than one year and the stocks and long-term bonds are traded in these markets. These securities are held by pension funds, insurance companies and large financial intermediaries.
Another type of the market is the cash or the spot market in which immediate deals between the parties are executed and this market is further divided into the primary and secondary market. The primary market or the issue market refers to a market where shares and bonds are issued. A suggestion is frequently stated that primary markets are vital for economies based on capitalism. These markets channelize the funds from the lenders to the borrowers and include several stakeholders which enable the mobilization of funds.
A market where the sale of previously issued securities is performed is referred to as a secondary market. The brokers have their specialization in the secondary market as they have superior knowledge of different factors like the risk and the return and the costs associated with different financial instruments.
Forward and futures markets also play their role wealth mobilization in a country. A contract made between the two parties on a private basis and contains one specific delivery date is referred to as a forward’s contract. In contrast to it, the contracts traded on an exchange are regarded as a futures contract and can be executed at a range of delivery dates.
Impact of Stock market indices on GDP
Keeping the discussion continued, it can be concluded until now that stock markets perform a reasonable job of the mobilization of funds in an economy. Theory suggests that when stock prices increase, they should exactly meet the real GDP growth. The economy which is underlying of a country can be expressed in terms of an entity’s profits and later into EPS (Earnings Per Share) which are used to determine the stock price of a company. This will work only when the economy is closed, the valuations are kept constant and the companies that are listed on the stock exchange are domestic.
In the context of the relation between the S&P 500 index returns and the GDP per capita of the US, one should have sufficient knowledge regarding the factors influencing both variables. The stock index returns are influenced by several micros and macroeconomic factors. The literature in this context identifies that the stock markets returns are greatly influenced by the change in macroeconomic information in case of developed financial markets, but the results for the emerging and developing economies are not inconclusive. Further research in both regimes of developed and non-developed markets is still required.
Research has identified a negative relation between the expected inflation and that of the long-term earnings growth. It was further discovered that the adjustments in inflation can weakly estimate the returns generated by stocks. A further study was conducted by incorporating the real GDP and its components, inventories and investments, government and personal consumption, exports and imports, GDP deflator and the consumer prices, unemployment and unit labour cost, long term and short-term interest rates, trade balance and the real rate of exchange were taken as macroeconomic variables and a time series analysis was performed by providing non-linear, time-varying, linear and pooled forecasts for the aggregate EMU variables. The good performance of non-linear models was well observed and the linear specification on average also performed well.
Another study was conducted in the context of the Sri Lankan stock market and macroeconomic variables were considered including money supply and treasury bill rate and CPI and it was observed that the other variables had a significant impact except for exchange rate on the stock prices in this regard. A similar study was performed in which data from 1973 to 2004 was obtained and various statistical tests like ADF test, Unit root test and the VCM (Vector Error Correction Model) by considering the industrial production index. A significant relation was also observed there in case of money supply, industrial production index and CPI and the investment earnings value. Therefore, it also reflects that the economy of USA can also have similar effects from the stock market. Therefore, money supply and demand in products relates to the GDP and other factors.
A study was conducted on the excess stock returns in the context of Singapore Real Estate by considering the 5 macroeconomic variables to observe the time variation and it was concluded that the risk premium on the stocks of real estate varies by time. A short term and long-term relationship between trading volumes, money supply and inflation were observed but it was found that there is no relationship between exchange rates and the stock prices in the case of Athens stock market.
A time-series analysis of stock market volatility between 1988 and 2004 was performed on the Thailand stock market and the other indices were Australia, Argentina, Hong Kong, Japan, Germany, Indonesia, UK, Taiwan and the US. The results of the study identified that the major variables of macroeconomic nature have a major effect on the Thailand stock index.
A time-series analysis of the years between 2000 2005 was performed using descriptive statistics, EGARCH & ARCH approach, Unit root test & ADF and the VAR model. The key macroeconomic variables that were taken into account included the supply of money, CPI, exchange rate, industrial production and the rate of interest. The results generated by the model of GARCH explicitly stated that the stock returns were responsive to the CPI and the money supply. In addition to it, the VAR model was able to explain the money supply and the CPI. The industrial production was reported positive by the VAR model but not significant.
Another test was conducted based on data collected every month from 1997 to 2005 by employing different tests like MLR (Multiple Regression), ADF (Augmented Dickey-Fuller) and PP(Phillip Perron) tests of stationary. The study suggested the negative impact of the rate of interest on the prices of the stocks the interest rates are regarded as the best alternative investment strategy.
A study was conducted using the ADF test on BRIC countries in terms of the oil prices and exchange rate. The data on the monthly prices between 1999 and 2006 has been taken into account. The study concluded that the relationship exhibited by the exchange rate and oil price on the market prices was insignificant.
A study which was conducted on the Malaysian stock market and it revealed that there are dynamic relations with the reserves and the industrial production index than the interest rate, money supply and exchange rate. Such literature shows that the macroeconomic factors such as GDP and inflation are the points which reflect the stock market of the country.
In addition to the above-mentioned empirical studies, there are some other factors which can impact the stock returns in a given scenario specially related to the economy of US. The fundamental factors due to which the stock prices can be primarily determined also affect the stock market index and the returns. These factors are determined with the help of two factors, the first factor is the earning base and example of it is the earnings per share. The second factor is a valuation multiple such as the price-earnings ratio. A person having a certain portion of common stock in his own will have a claim on the earnings of the company and EPS is used as an indicator of the shareholders’ claim on the earnings of the company….