Academic journal article Quarterly Journal of Business and Economics

Stock Returns and Real Activity: New Evidence from the United States and Japan

Academic journal article Quarterly Journal of Business and Economics

Stock Returns and Real Activity: New Evidence from the United States and Japan

Article excerpt

Introduction

The fundamental value of a firm's stock is the expected present value of future dividends. Future dividends must reflect real economic activity. Past research and conventional wisdom support the notion that asset prices reflect economic news. If all currently available information is taken into account, there should be a close relationship between stock returns and expected future real activity. To the extent that stock prices react quickly to new information about the future, stock prices should be leading indicators of real activity. The absence of any correlation between stock returns and future production growth rates would suggest that stock prices do not accurately reflect the underlying fundamentals of value.

There is a considerable literature on the relationships among real, monetary, and financial variables. (1) Fama (1990), among others, finds that stock returns can be significant in explaining future real activity in the United States. Fama finds that monthly, quarterly, and annual stock returns for the period from 1953 to 1987 are highly correlated with future production growth rates. Past stock returns are significant in explaining current production growth rates, and future production growth rates are significant in explaining current stock returns. Moreover' the degree of correlation between stock returns and future production growth rates increases with the length of time over which returns are calculated. Variations in annual returns are explained well by future production growth rates, whereas they only explain a small fraction of monthly returns. Fama (1990, p. 1094) explains that information about a certain production period is spread over many previous periods, and thereby affects the stock returns of each of those periods. In that way, the short-horizon return holds information about the production growth rates of many future periods, but adjacent returns hold additional information about the same production growth rates. As a result, regressions of long-horizon returns on future production growth rates (or regressions of long-horizon production growth rates on past returns) give a better picture of the cumulative information about production embodied in stock returns.

Schwert (1990) analyzes the relation between real stock returns and real economic activity from 1889 to 1988. He replicates Fama's (1990) results using an additional 65 years of data. Fama's findings are robust for this much longer period, with future production growth rates explaining a large fraction of the variation in stock returns. The Fama-Schwert findings establish a relationship between industrial production growth rates and lagged real stock returns in the U.S. Choi, Hauser, and Kopecky (1999) examine the relationship between industrial production growth rates and lagged stock returns for the G-7 countries using cointegration and error-correction models. They use monthly and quarterly data from January 1957 through March 1996 to show that the lag levels of industrial production and stock prices were cointegrated in all of the G-7 countries. Over a short time horizon, the error-correction models indicate that the growth rate of industrial production is correlated with lagged real stock returns at some data frequencies in six of the G-7 countries, with Italy being the only exception.

Binswanger (2000) speaks to the importance of expanding on Fama's work and does so with the same types of testing methods and data used by Fama (1990). Our research extends the investigation into this topic with cross-cultural comparisons and the application of new econometric methods. Park and Ratti (2000) investigate the dynamic interdependencies among economic activity, inflation, stock returns, and monetary policy. Their monthly U.S. data cover the period from January 1955 through March 1998. Using a vector autoregression (VAR) model, they find that shocks from monetary tightening generate statistically significant movements in inflation and expected stock returns and that these movements occur in opposite directions. …

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