Academic journal article IUP Journal of Applied Economics

What Determines Stock Returns? - A Comparative Study of the Effects of Fiscal, Monetary and Trade Variables

Academic journal article IUP Journal of Applied Economics

What Determines Stock Returns? - A Comparative Study of the Effects of Fiscal, Monetary and Trade Variables

Article excerpt

(ProQuest: ... denotes formulae omitted.)

Introduction

Economists and finance specialists have long studied stock markets. Some have tried explaining its determinants, while others have studied regional and international linkages, all in a bid to better explain and predict returns. The relationship between stock returns and different macroeconomic fundamentals has been analyzed following the Arbitrage Price Theory (APT) established by Ross (1976) and later extended by Connor and Korajczyk (1986). The attempt was to model expected returns as a function of various macroeconomic factors. The general conclusion of the theory is that an additional component of long-run return is required and obtained whenever a particular asset is influenced by systematic economic news and that no extra reward can be earned by bearing diversifiable risk.

However, the APT does not in itself say which factors explain returns best or even if they capture the entirety of the situation, which is more of an empirical question. It has been silent about the identity of these necessary factors in trying to determine stock market returns. After a decade, Chen et al. (1986) posited that five economic variables-industrial production, unanticipated inflation, changes in anticipated inflation, twist in the yield curve and changes in risk premium-are plausible sources of common variation among equity returns. Their cross-sectional regression-based empirical study finds that industrial production, anticipated inflation and risk premium are significant factors. Evidence for the remaining were mixed and varied with the period of investigation, importantly the New York Stock Exchange on which the testing was done despite being a weighted index could not significantly predict future time series variability of its' own returns. A problem with the approach was that the variable selection was very subjective. Subsequent literature has tried to identify and explain a few variables which by and large explain stock market returns in a country. This practice in tune with the APT makes the residuals as small as possible, so as to minimize the unexplained or arbitrary part of the stock returns. The theory highlights the below listed variables the most:

Inflation: Theory by and large gives two views on relation between inflation and stock returns. The first and earlier view draws on Fisher (1930), who stated that expected rates of return consist of a 'real' return plus the expected rate of inflation and the real return does not move systematically with the rate of inflation. In short, investors will on average be fully compensated for erosion in purchasing power. However, another view supported by Geske and Roll (1983) argues that a rise in expected inflation rate leads to restrictive monetary policies, which would increase the interest rates and hence have a negative effect on stock market activity. The effect of high interest rates would not be neutralized by an increase in cash flow resulting from inflation, but cash flows do not grow at the same rate as inflation. Hence, theoretically it is still a matter of debate (Fama, 1981).

Index of Industrial Production: Fama (1990) determined that the growth rate of industrial production had a strong concurrent relation with stock returns. The productive capacity of the economy is dependent on the accumulation of real assets, which in turn contribute to the ability of firms to generate cash flow. Measure of industrial production which is a proxy for real activity is pro-cyclical (Tainer, 1993). Therefore, a rise in industrial production signals economic growth, meaning higher returns.

Interest Rate: Theory dealing with stock returns and interest rate does so by observing firm behavior; higher interest reduces the attractiveness of investment for firms, thus shrinking the value of stock returns and hypothesizing a negative relation between the two. Also most firms finance their capital by borrowing, so a reduction in interest rates reduces the costs of borrowing and has a positive effect on returns. …

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