Do Economic Fundamentals still Matter for the Stock Market?

Thursday, 25/04/2013

By: Laopodis Nikiforos T., Associate Professor of Finance

Theoretically, equity prices should be related to future economic activity movements because a firm’s projected earnings growth depends on the health or weakness of the economy. If we think of the stock market as a forward predictor of real economic activity, then the fundamental value of a firm’s stock must be equal to the discounted expected cash flows (that is, dividends).Expected dividends, in turn, should reflect real economic activity as measured by the country’s Gross Domestic Product or industrial production. However, stock prices are affected by other important fundamental variables such as market interest rates, which influence the firm’s risk premium and discount rate, and inflation, which directly influences the market interest rate. Thus, movements in these and other economic variables such as the unemployment rate should be linked to changes in business conditions and capture variations in a firm’s future cash flows and thus stock prices.

There is ample evidence on the linkages between macroeconomic fundamentals and stock returns in the empirical financial literature. For example, some researchers have found strong short-run correlations between the two magnitudes as well as among these magnitudes and other financial variables for the United States (US). Significant empirical research also exists for several major international stock markets which also documents the same important linkage between stock returns and real (aggregate) economic activity.

However, there has been an increasing concern that stock market movements could be explained by economic fundamentals during the last twenty years or so. This concern surfaces not only for the US’ stock market but also for European and Asian markets when their stock markets witnessed unprecedented highs in the mid 1990s but were sharply reversed in the early and late 2000s as a result of excessive speculation. Two early studies argued that most of the rise in equity prices during the second part of the 1990s in the US was not due to fundamental values such as projected earnings growth or dividends but to exogenous shocks and/or market irrational behavior. Along the same lines are the findings of other researchers who reported that discount rates, earnings, dividends, industrial production (all fundamental variables themselves) did not help explain stock price movements. Specifically, new sources of variation in stock returns have emerged since the boom years of the 1990s which could not be explained by the class of models according to which the stock market may be a leading indicator of real economic activity. Unambiguously, these studies find that real activity explained only a small fraction of the variation in real stock returns in the US, Japan, and the aggregate European markets.

What are the implications of this disconnection between stock markets, or the financial economy, and economic fundamentals, or the real economy, for the economy as a whole? In general, it has been found that equity markets significantly move the real economy as follows. First, higher stock values create the usual wealth effect (which is the feeling that consumers have when their investment asset values increase); second, higher stock prices of big corporations lower the cost of raising new capital thereby contributing to increases in business investment; and third, the booming stock market has the (rational) effect of increasing consumer and business confidence. Rising confidence in the economy, in turn, keeps business and consumer spending at higher levels, and the lower cost of raising capital provides further incentives to firms to increase investment spending, thus contributing to higher economic growth. However, if there is a disconnection of the stock market from the real economy all above benefits are reversed.

What are the implications of this disconnection for the average person, whether a consumer or investor? If a nation’s equity market is detached from the real economy then the stock market’s gains would not translate (or spill over) to the real economy in the forms of higher employment opportunities, higher incomes, more capital spending by businesses and higher government revenues. Absence or reduction of the latter, for example, would impact all economic participants because government services would be reduced and would probably force the government to raise future taxes to operate, thus reinforcing the vicious circle. Obviously, consumers would be hurt by being deficient in buying goods and services, businesses would not see their goods and services

How real is this scenario? Just look at what happened in 2007, now known as the global financial crisis of 2007/8 which spilled over from the US to Europe and other continents. The housing bubble in the US, the cause of the crisis, was fueled by complex financial instruments designed to enable subprime borrowers to become homeowners, the lack of disclosure of information about banks’ and insurance companies’ true financial backing for such risky loans, widespread fraud and pure greed, among others. These practices were at odds with the real financial capacity of people and banks, which was partially reinforced by lax regulatory and supervisory authorities and totally disconnected from the real economy. The US and other affected countries responded to the crisis with an unprecedented expansion of money in a concerted effort to save the (global) financial system and sustain the real economy (as well as restore economic fundamentals!). Now, just imagine what will happen in the (near) future with all that money flowing around (within the general financial system) without being injected in the real economy to finance business projects and combat unemployment. The global banking system has, instead, used the cheap money it got to invest in (and speculate with) higher-yielding instruments worldwide, effectively closing its eyes and ears to the economic woes of the countries still plagued by the crisis. In other words, the financial and real sectors disconnection is growing and global risk is increasing. Thus, it remains to be seen what this increasing appetite for higher yield also has in store for the global economy in the coming months (or next year).

Suggested Literature

Cheung, Y-W., and L.N. Ng, 1998. International evidence on the stock market and aggregate economic activity. Journal of Empirical Finance 5, 281-296.

Carlson, J.B., Sargent, K.H., 1997. The recent ascent of stock prices: can it be explained by earnings growth or other fundamentals? Federal Reserve Bank of ClevelandEconomic Review 33 (2nd quarter), 2-12.

Fama, E.K., 1990. Stock returns, expected returns, and real activity. Journal of Finance45, 1089-1108.

Laopodis, N. T., 2006. Dynamic interactions among the stock market, federal funds rate, inflation, and economic activity. The Financial Review 41, 513-545.

Laopodis, N. T., 2011. Equity prices and macroeconomic fundamentals: international evidence. Journal of International Financial Markets, Institutions and Money 21, 247-276.

Lee, B.-S., 1995. Fundamentals and bubbles in asset prices: evidence from the US and Japanese asset prices. Financial Engineering and Japanese Financial Markets 2, 69-122.

Shiller, R. Irrational Exuberance. 2005. Princeton University Press.