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Causality Relationship Between Sectoral Stock Market Indices and the US Economy

Chapter Two: Literature Review

2.1 Overview

The purpose of this chapter is to extend the knowledge of research key area that is “Causality relationship between sectoral stock market indices (Plus stock market indices) and the US Economy”. This chapter include analysis of previous studies to identify specific areas that are already covered in previous literature through which literature gap can be identified. This study contributed for identifying this relationship and how changes are occurring in US market overtime. A stock index indicates the average price change of a stock basket, called the theoretical portfolio, over a given period. Their values are expressed in points and their variation is measured as a percentage. The indices will differ according to the segments they represent. Their portfolios may represent certain industry sectors, most traded securities, larger companies, differentiated corporate governance levels, or another specific category.

2.2 Stock Index Analysis

An investor before making any decision needs to assess current market trend. One way to do this is by tracking indices, which serve to indicate the general trend of the market and its likely meaning. There are currently numerous indices and each expresses a specific portion of the market (Baumöhl & Lyócsa, 2017). Each investor has a preference for one or the other, according to their composition and according to the sector of interest. In contrast to this, A Market Index,It is a kind of benchmark, which serves as an indicator of the state and general trend of capital market developments that it represents, giving indications about the likely direction of evolution of that market or, if the index is a sector index, about the probable sense of evolution of segments of that. These indices are made up of ‘aggregations’ of securities of the same type (stocks or bonds) and more representative of the market (Kagel and Roth, 2016).  There are also volatility indices and indices that seek to reflect investor sentiment. The importance of market indices for investors as market benchmarks is due to the fact that there is a strong correlation between the prices of different securities, that is, prices tend to follow a group movement, devaluing or appreciating together.
A stock index is an indicator of the performance of a theoretical equity portfolio. The indices are intended to serve as indicators of the average behaviour of the market or of a specific economic segment, such as restricted and sectoral indices (Brickley, Smith and Zimmerman, 2015). It is the benchmark that indicates whether the market is up or down. Each exchange builds its own indices, made up of a set of assets. The daily result that the exchange discloses is the average taken from the individual behavior of these securities. The index will also serve as a benchmark for assessing whether investments are yielding above, below or near the market average, as well as defining what the long and short term trend of the overall market is. The two most important indices in the global stock markets are the Dow Jones index and the S&P 500. The investor should always be following these indices, seeking to identify the general trend of the market. In general, the other world indices follow the S&P 500 and the Dow Jones in US market the relationship between them is usually very strong. In relation to this, S&P 500 index and Dow Jones index of US for the last five year presented in the following;

Figure 1: S&P 500
(Source: Yahoofinance.com)

Figure 2: Dow Jones Index
(Source: Yahoofinance.com)

2.3 Evolution of Stock Market Indexes

The evolution of stock market indices is extremely important information for analysts, investors and speculators in the valuation of their investments, serving as a performance standard for them. When the exchange is said to close “up”, that means that the S&P closing price for a given trading session is higher than the previous trading session closing price (Marketwatch.com. (2019).  Therefore, it is said that the exchange closed “down” when the S&P closing price of a certain trading session is lower than closing price of the previous trading day, and “stable” when the closing price is at the same level as the previous trading session closing price. The main indices of the market are:
Dow Jones Industrial – The Dow Jones Index was created in 1897 by Charles H. Dow who was the first to observe that stocks tend to move together, following the most representative trajectory, so that the general market trend can be measured. Their selection criteria for group actions are extremely conservative. The calculation of this ratio is quite simple, based on the stock price of 30 largest and most important companies of United States (Li et al., 2016). The Dow Jones Index (DJIA) is adjacent to the Nasdaq Composite and Standard & Poor’s 500, one of the main indicators of US market movements. Of the three indices, the DJIA is the most widely published and discussed, however, it is not a good market gauge for the S & P 500 because it is calculated on few assets and whose weights are unbalanced. It is his fame that makes him so important, which ultimately influences market movements in general.
S&P 500 – The S&P 500 Index was created in the late 1950s by Standard & Poor’s Co. Economic News and Research. It is an index composed of 500 qualified assets (equities) due to their market size, liquidity and its representation of industrial group (Cervelló-Royo, Guijarro & Michniuk, 2015). These shares represent 86% of the total aggregate value of the most important shares in the market. As a result, the index turns out to be a general indicator of the US stock market.

2.4 Sectoral Index

Standard & Poor’s 500 (S&P-500) is the index of 500 separate Wall Street stocks on the including the New York Stock Exchange (NYSE) and NASDAQ. These are specialized indices designed to measure the performance of particular industries or specific sectors of activity. One example, among many others, is the Morgan Stanley Biotech Index, which covers 36 US companies in the biotechnology industry (Chong, Han, & Park, 2017). In addition to these indices, all of which refer to stock markets, there are also other non-stock indices that have an impact on bond prices, including: (i) Currency indices – assess the value of a country’s currency relative to foreign currencies selected; (ii) Commodity Index – include securities and derivative securities related to commodities; (iii) Sentiment indices – assess investor expectations about short-term volatility and generally derive from option prices. According to Brickley, Smith and Zimmerman, (2015), that types of indices are determined by the markets they represent, the type of securities they encompass, or the sectors of activity of the companies issuing said securities. In relation to this, other index that are trading in US is Global Indexes – These are indexes that include some of the largest companies in the world located in different countries. For example, the MSCI World Index provided by MSCI Inc., measures 1500 stocks in various developed markets around the world and is commonly used as a benchmark for global equity funds. Moreover, there are National Indices – National indices seek to demonstrate the stock performance of a specific country, reflecting the general sentiment of investors who are active in this market (Marketsmith.investors.com, 2019).  Good examples of national indices are Dow Jones and NASDAQ in the United States, CAC 40 in France, FTSE in the United Kingdom, DAX-30 in Germany, Hong Kong has Hang Seng index, BOVESPA in Brazil, PSI-20 in Portugal and Nikkei 225 in Japan.

2.5 US Market Index

United States Stock Market Index data were recorded at 13,049.7 31-Dec-2002 = 5000 at 2019-06. This is a record of an increase from previous figures of 12,264.5 31-Dec-2002 = 5000 at 2019-05. United States Stock Market Index data are updated monthly, with an average of 2,438.0 31-Dec-2002 = 5000 for 1965-12 to 2019-06 with 643 observations. Data reached a record high of 13,368.0 31-Dec-2002 = 5000 in 2018-01 and a low record of 353.7 31-Dec-2002 = 5000 in 1974-09 (Marketsmith.investors.com. (2019). US stock market index data maintain active in CEIC status which is reported from some sources: CEIC Data. Data are classified in the World Trend Plus’ which is known as the Global Economic Monitor – Table US.Z001: NYSE: Indexes. Another trading unit in the United States is the crypto currency that has higher profitable signals. Investors require to invest $ 49.90 per month and have access to opportunities of over 500% annual profit In addition to this, the ranking top five companies in the US stock include the following; Thus the list is presented in the order of accumulated performance in the year (YTD). So it is based on the opening share price from January 2, 2018 and closing price from December 14, 2018: the workday Inc. has the higher ranking with market Cap: $ 35.06 billion And there is positive change over time that worth of $ 58.63 and its comparative performance with NASDQ is increasing 57%. The second rank of the company is Illumina, Inc. that has market cap of $ 47.45 billion with the positive change of $ 102.43 with 46% return of composite index. Third ranking of market index is for O’Reilly Automotive, Inc with market cap of 27.55 billion that has positive price change of $98.91. Additionally, Twenty-First Century Fox, Inc ranks four with the Market Cap of $ 91.14 billion. Moreover the fifth rank is for the Netflix Inc. that has market cap of $ 118.48 billion with positive price change of $ 65.77 during last year. This is showing positive growth in the sectoral market overtime (Marketsmith.investors.com, 2019). In contrast to this, Amazon, which owns the most liquid stocks in the United States, averages $ 7.49 billion a day, 2.84 times larger than the entire US stock market (Baruník, Kočenda & Vácha, 2016).

2.6 Macroeconomic Elements

2.6.1 Inflation and stock market return
Inflation in the United States has been increasing since the beginning of this year, largely due to growing oil prices. The US consumer price index rose 0.2% in May from the previous month and the annual inflation rate rose to 2.8%, the highest since 2012, according to data released. Underlying inflation, which excludes energy and food prices due to their higher volatility, also stood at 0.2% last month and compared to May 2017 rose by 2.2%, according to data. Inflation in the United States has been rising since the beginning of the year, largely due to rising oil prices. The 2.8% rate is the highest in the United States since February 2012 (US Inflation Calculator, 2019). The consolidation of the upward trend may serve as an argument for an expected interest rate hike by the Federal Reserve, which begins a monetary policy meeting.

Figure 4: Inflation

(Source: usinflationcalculator.com)
The reason for the above trend is because the improvement in production for the current period has already been anticipated and therefore incorporated into asset prices in previous periods. Therefore, the impact reflected by stock prices in the current period is due to the contractionary reaction of policymakers to increase the inflation rate. The literature on the causal relationship between economic growth (EC) and Sectoral market is not yet conclusive. According to Prieto Eickmeier, Marcellino,(2016), the works that dealing with the relationship between financial development and economic growth can be grouped in four lines. First, financial development and economic growth are not relate, the correlation found between them is spurious. Second: financial development is economic growth, that is, financial development is driving by demand. Higher growth provides greater scale for the financial system with the consequent fall in fixed costs, sophistication of products and services. In relation to this, Caldara, et al., (2016) claims that historical observations show that financial development was more supply-inducing that driven by demand. Third, financial development is key to growth that is, financial development provides better monitoring of investment and increases savings which lead to increase investment. Finally, financial activity may be an impediment to economic growth, at least eventually, due to the periodic crises that the system financial crisis suffers (Olweny & Kimani, 2011). This work corroborates those in line with the third line of research. It has been found that different financial structures maintain a greater or lesser degree of information asymmetry between savers, financial intermediaries, investors and managers; and some degree of imperfection in market, with a possible decrease in investments and economic growth. This understood as imperfect market where information is asymmetric; an imperfect credit market leads to agency 3 problems between financial intermediaries and investors or between managers and investors (Gilchrist, Yankov, & Zakrajšek, 2009). In this regard, information asymmetry induces problems between savers and investors
The solution to this problem is credit rationing which is suggested by Banda, Hall, and Pradhan, (2019) which leads to a lower number of investments compared to what would occur in a market with perfect information. Another way to solve the problem would be use specialized as intermediaries between savers and investors. However, this solution depends on the degree of development in the stock market. They are found in the literature as several researcher works that corroborate the dependency thesis and others that contradict it. Therefore, It was considered relevant to test whether the development of sectoral market indices contributes to the country, from 2000 to 2018, a period in which there was great growth in the as well as volatility in this growth. There is a fruitful debate about the best design of a financial system – about the capital markets division (Ozbay, 2009). Based on the examples from Germany and Japan, some argue that the system based on banks is better because it allows long-term investments to be made without pressure from short-term result, carried out by non-managing shareholders. On the other hand, looking at examples from the United States and England, it is argued that the capital market is better for the banks take ownership of part of the companies’ profits, thus reducing their investment capacity, which does not occur in the capital markets. This capacity for appropriation is directly linked to the degree of banking concentration and the presence of other types of institutions competing with the banks in the financing process. Countries like Germany and Pakistan have their systems based on banks and belong to different groups regarding growth. United States and Philippines have system based on capital markets and also belong to different groups. However, Germany and the US have different systems but similar historical growth. The same parallel can be done on Pakistan and the Philippines.

2.6.2 Fed Rate and stock market returns

Federal Reserve officials are expected to neglect the rise in the last quarter and focus on a measure of domestic demand, which rose at a rate of only 1.3%, the slowest since Q2 2018, after growing 2.6%. Fund warns, however, of the drop in life expectancy in the country, and points out that 45 million Americans live in poverty. The International Monetary Fund (IMF) has raised growth forecasts for 2019 and 2020 for the United States, while warning of the damaging consequences of the Sino-US trade war. The Washington-based institution, which had lowered its forecasts in April, now estimates that US Gross Domestic Product will grow 2.6% (+0.3 points) this year and 2% (+0.1 points) in the next year (Imf.org, 2019).
According to the Fund, the fiscal stimulus implemented between 2017 and 2018 helped lead to 2.9% growth last year, but as the effects of that stimulus weaken, expansion is expected to revert to around 1.25%. “The risks are globally balanced,” says the IMF in its annual report on the world’s largest economy (Bea.gov. (2019). The Federal Reserve (Fed) kept its interest rates in the range of 2.25% to 2.50% on Wednesday. In a statement after the two-day meeting, the monetary authority also said it no longer expects to raise interest rates this year. Now, the Fed only plans to increase only until 2021. Until September last year, members of the Federal Open Market Committee (FOMC) projected to raise interest rates three times in 2019. The last time rates rose was in December – in 2018, they were four hikes. FOMC members pointed out that information received since the January meeting indicates that the labour market remains strong, but that economic activity performance has slowed compared to the fourth quarter. The Fed also said it will slow its monthly portfolio reduction from as much as $ 30 billion today to as much as $ 15 billion from May….