In the stock market, the utilization of information is of the essence, and being able to draw conclusions about what factors empirically affect stock market returns is valuable information for all investors trying to get an edge in the market. Ignoring firm-specific information such as news and accounting-specific data relevant for only a particular firm, economy-wide structural information about the macroeconomy is bound to give information about future stock market returns.foto: Markus Spiske
In the stock market, the utilization of information is of the essence, and being able to draw conclusions about what factors empirically affect stock market returns is valuable information for all investors trying to get an edge in the market. Ignoring firm-specific information such as news and accounting-specific data relevant for only a particular firm, economy-wide structural information about the macroeconomy is bound to give information about future stock market returns. As the stock market tends to follow the trend of the general economy, the hypothesized relationship between the macroeconomy and stock market returns would be no surprise. The transmission from which macroeconomic indicators affect stock returns depends on their respective effects on the economy as a whole; for instance, firm sales (consumption rates) are often tied together with unemployment, inflation, GDP, and monetary changes in the money supply and interest rates. Since macroeconomic indicators affect all firms simultaneously, if there were to be any stock market effects it would be felt through the whole market, not just particular stocks.
The importance of market selection
All markets are not created equal, hence, the macroeconomic effect is dependent on the particular structure and size of the market, so a uniform effect on markets is not to be expected. Small and developing markets tend to be more sensitive to structural changes than large and developed stock markets. This is, of course, interconnected with the theory of market efficiency, and how information is absorbed differently across markets.
The heterogeneous effects across markets are widely documented in the academic literature. However, the empirical evidence is far from unambiguous in the predictability of stock market returns. Studies from the U.S, examining the same macroeconomic effect, finds conflicting results using similar data, suggesting that the effect very much depends on the time period examined and the method to find the relationship.
Which macroeconomic indicators should be used?
Again, choosing which indicators should be included when trying to retrieve valuable information from the macroeconomy is not easily answered in the academic literature. However, the most common ones are interest rate, inflation rate, exchange rate, yield curve spread, and unemployment. The reason for not including GDP as an indicator is usually due to its strong interdependence with unemployment and the interest rate.
In a theoretical sense, the relationship between these indicators and stock returns are well documented: the relationship between the interest rate and stock returns is negative which is due to the fact that increases in the interest rate dampers consumption which lower sales in the economy; the inflation rate should have a negative effect on returns since inflation decreases the purchasing power, and higher prices often affect firm profits negatively; the yield curve tends to have a positive relationship with stock returns since increases in the interest rate term-spread indicates growing stability of the economy; the unemployment is also expected to have a negative relationship with stock returns since increases in the unemployment tend to reduce firm sales and profits since unemployed consumers consume less.
Empirical evidence from Sweden
Using data from Sweden, a recent study finds some interesting results on the effect of macroeconomic indicators on the Swedish stock market (OMX). The stock market is defined as three separate markets: large-cap (OMXS30), mid-cap (OMX mid-cap index), and small-cap (OMX small cap index). Since the macroeconomic effects tend to affect the economy slowly, the effect is decomposed into two different intervals, one-month, and four-month lagging effects.
Interestingly, the effects on each of the three markets were very different, however, the indicators that showed significant results were fairly consistent across markets. So, to answer the question on which indicators should be used to gain information about future stock returns are: the Swedish interest rate, inflation rate, and yield curve.