(Photo: Dr. Bill Sackley with students in the Financial Trading Room of the Computer Information Systems building)
Guest Blogger: Dr. Cetin Ciner, professor of finance at the Cameron School of Business
Stock prices, if determined in rational and operationally efficient markets, should reflect future profits. Since the earnings of corporations should be highly correlated with economic activity, stock-price changes should reflect the market’s expectations of economic growth.
In fact, according to this view, the overall stock market can be viewed simply as a mirror image of the overall consensus of traders about the future of the economy. In other words, the stock market should be used as a leading indicator for economic growth, and fiscal and monetary policy-making. This is why the Dow Jones composite index was included in the initial list of leading indicators for the economy.
This theory seemed to hold well when data from the 1950s to the early 70s were investigated by past researchers. However, when subsequent researchers included data from the 1980s and the 90s, the correlation between current stock valuations and future economic growth largely disappeared. Some researchers have even suggested that the stock market was driven by fads or bubbles after the 1980s, since it no longer reflected fundamental values.
I revisited this issue in a recent Cameron School of Business working paper. In a detailed econometric study, I looked at the time variation in the predictive power of the stock market for economic growth. I examined predictive power of the short-term (one month ahead) and long-term (12 months ahead). In the below graph, I present the results for the time varying explanatory power of the stock market for 12-month-ahead economic growth by using a relatively new technique called forecast error variance decomposition.
The vertical axis shows the percentage of economic growth explained by the stock market. As the graph illustrates, the predictive power of the stock market shows a steady decline after the 1970s, a finding consistent with prior work.
However, the chart also reveals that the predictive power of the stock market has gained new traction over last decade. In fact, in most recent data, the stock market regains its leading indicator status and explains 50% of the future of the economy. This is a remarkable forecasting success for the stock market and suggests that the stock market should again carry weight in the consideration of policymakers. Furthermore, it is good news for stockholders, as the rally of the last few years do not seem to be out of touch with fundamentals.
Of course, there is always a bit of caution because the relation could again decay. However, for the moment the stock market seems to be behaving rationally.