Economic Indicators
The U.S. economy is a very complex system, with indicators therefore ambiguous and difficult to interpret. To what degree do macroeconomics and the stock market go hand-in-hand, if at all? Do investors/traders: (1) react to economic readings; (2) anticipate them; or, (3) just muddle along, mostly fooled by randomness? These blog entries address relationships between economic indicators and the stock market.
POMO, TOMO and Stock Returns May 25, 2011
A reader hypothesized that the Federal Reserve uses Open Market Operations repurchases to stimulate, or prop up, the stock market. The hypothesis supposes that private parties, such as prime brokers, use the funds released by these repurchases to buy (highly leveraged) stock futures contracts, immediately attracting arbitrageurs who simultaneously short futures and purchase stock indexes. Trend followers then pile on. The Federal Reserve states that open market operations regulate “the aggregate level of balances available in the banking system,” thereby keeping the effective Federal Funds Rate close to a target level. The operations are predominantly repurchases, whereby the Federal Reserve provides liquidity. Do these Permanent Open Market Operations (POMO) and Temporary Open Market Operations (TOMO) affect the U.S. stock market? In other words, do the managers of POMO and TOMO transactions act as a “Plunge Protection Team?” Using accepted Treasuries repurchase transaction data for POMO during 8/25/05 through 5/20/11 (323 transactions) and TOMO during 7/7/00 through 5/20/11 (2,590 transactions) and contemporaneous daily and monthly closes of the S&P 500 Index, we find that: More…
Predicting Variation in the Size Effect May 18, 2011
Does the size effect vary in a predictable way? In the May 2011 version of his paper entitled “Explaining the Dynamics of the Size Premium”, Valeriy Zakamulin investigates relationships between eight market/economic variables and the size effect in U.S. stocks to identify the best model of size effect variation. The eight variables are: (1) stock market return; (2) stock market dividend yield; (3) equity value premium; (4) stock return momentum; (5) default spread (Moody’s BAA-AAA corporate bond yield spread); (6) Treasury bill yield; (7) U.S. Treasuries term premium (30-year bond yield minus one-month bill yield); and, (8) inflation rate. He then tests the exploitability of the best model via a strategy that switches between small-capitalization and large-capitalization stocks out of sample based on inception-to-date historical data. Using annual data for the eight potentially predictive variables and annual and monthly data for the magnitude of the size effect among NYSE, AMEX and NASDAQ stocks as available over the period 1927 through 2009 (83 years), he finds that: More…
Fed Model Respecified? May 6, 2011
The Fed Model relates the aggregate earnings yield (E/P) of the stock market to Treasury bond or bill yields under the assumption that investors view equities and government bonds as competing ways to achieve yield. Might supply (company management), rather than demand (investors), more precisely drive the relationship between E/P and interest rates? In the April 2011 (incomplete) draft of his paper entitled “Understanding the Fed Model, Capital Structure, and then Some”, J.H. Timmer argues that the stock market earnings yield tends to equilibrium not with the government bond yield but with the average after-tax corporate bond yield as companies adjust capital structure (mix of equity and bonds) to maximize earnings per share. SEC Rule 10b-18 (explicitly allowing share repurchases) enabled fine adjustment toward equilibrium as of 1982. Using annual estimates of one-year forward earnings yields and corporate bond yields for a subset of S&P 500 companies and assuming a constant corporate tax rate of 30% over the period 1968 through 2006, he finds that: More…
Are Homebuilder Stocks Early Warning Indicators for Equities in General? February 24, 2011
Does the behavior of the stocks of homebuilders anticipate the overall equity market? To check, we first assemble a simple index of the performance of homebuilder stocks as the equally-weighted average monthly return for the stocks of DR Horton, Hovnanian, KB Homes, Lennar, Ryland and Pulte, starting with Pulte in August 1985 and adding the others as they are listed. Comparing these returns with monthly returns for the S&P 500 Index data for August 1985 through January 2011 (306 monthly returns), we find that: More…
Lead-lag Relationships for Stocks, FFR and Treasuries February 23, 2011
Are there reliable lead-lag relationships among stock market returns, changes in the Federal Funds Rate (FFR) and changes in Treasury bond yields? In their February 2011 paper entitled “The US Stock Market Leads the Federal Funds Rate and Treasury Bond Yields”, Kun Guo, Wei-Xing Zhou, Si-Wei Cheng and Didier Sornette apply a new “thermal optimal path” method to test whether: (1) U.S. stock market returns and changes in U.S. Treasury instrument yields have negative correlation; and, (2) FFR as a proxy for U.S. monetary policy predicts U.S. stock market returns. The thermal optimal path method applies statistical methods of thermodynamics to determine the most likely relationship between stock market returns and FFR/yields. Using both monthly and weekly time series for the S&P 500 Index, FFR and U.S. Treasury instrument yields grouped by short-term (three months to three years) and long-term (five years to 20 years) maturities over the period August 2000 through February 2010 (115 months), they find that: More…
Predicting Stock Market Returns Based on Fixed Business Cycle February 4, 2011
Does the concept of an idealized fixed business cycle help predict stock market returns? In his recent paper entitled “Forecasting 2011 Using U.S. Precedents: A Simple Analysis of Equity Market Performance”, Thomas Hall examines the performance of major U.S. stock market indexes at fixed intervals after business cycle troughs and extrapolates results to predict U.S. stock market returns for 2011. For extrapolation, he employs a regression relating returns during months 19-30 after business cycle troughs (equating to calendar year 2011 for the most recent trough) to returns during the immediately preceding months 1-18 after troughs. Using National Bureau of Economic Research business cycle trough months and monthly closes of the Dow Jones Industrial Average and the S&P 500 Index for trough months and months 19 and 30 after troughs as available since 1926 (14 and eight troughs before June 2009, respectively), he finds that: More…
Baltic Dry Index as Return Predictor January 31, 2011
Do variations in the Baltic Dry Index (BDI), a weighted average of the Baltic Exchange shipping cost indexes for the four largest dry-vessel classes, serve as an early measure of global demand for raw materials and thereby predict asset class returns? In the January 2011 version of their paper entitled “The Baltic Dry Index as a Predictor of Global Stock Returns, Commodity Returns, and Global Economic Activity”, Gurdip Bakshi, George Panayotov and Georgios Skoulakis investigate the ability of BDI to predict stock market and commodity market returns. They focus on three-month changes in BDI as a predictor to smooth the high volatility of the monthly series. Using monthly BDI levels and returns for four MSCI regional stock indexes, 19 developed country stock indexes, 12 emerging country stock indexes, three spot commodity indexes and industrial production data for 20 countries mostly over the period May 1985 through September 2010 (305 months), they find that: More…
Federal Funds Rate Size Effect? January 19, 2011
A reader noted and asked: “I have seen on the net that it is better to be in large capitalization stocks when the Federal Funds Rate (FFR) target is increasing and small capitalization stocks when the FFR target is decreasing. Is there any serious study about this belief?” An argument supporting this proposition is that investors view small firms as more sensitive to changes in interest rates than large firms. Using FFR target actions and daily closes of the S&P 500 Index (representing large firms) and the Russell 2000 Index (representing small firms) for January 1990 through December 2010, we find that: More…
Federal Funds Rate and the Stock Market January 18, 2011
Media commentators and expert advisors sometimes cite cuts and hikes in the Federal Funds Rate (FFR) as an indicator of U.S. stock market prospects, with decreases (increases) in FFR acting as a stimulant (depressant). Does the overall U.S. stock market respond systematically to loosening and tightening of credit as measured by cuts and hikes in FFR? Using FFR target changes and daily S&P 500 Index levels over the period January 1990 through December 2010, encompassing 76 changes in FFR (46 cuts and 31 hikes), we find that: More…
Enhancing Financial Markets Volatility Prediction January 13, 2011
Are there economic and financial variables that meaningfully predict financial markets return volatility? In the January 2011 draft of their paper entitled “A Comprehensive Look at Financial Volatility Prediction by Economic Variables”, Charlotte Christiansen, Maik Schmeling and Andreas Schrimpf investigate the ability of macroeconomic and financial variables to predict volatility of returns for four major asset classes (foreign exchange, bonds, stocks and commodities). To calculate return volatilities, they use: (1) spot price changes for various currencies against the U.S. dollar for foreign exchange; (2) 10-year Treasury note futures contract prices for bonds; (3) S&P 500 Index futures contract prices for stocks; and, (4) S&P GSCI commodity index levels for commodities. They use an autoregressive (simple volatility persistence) model as a benchmark. Using monthly observations of 29 macroeconomic and financial variables and realized return volatilities for the four asset classes during 1983 through 2008 (311 months), they find that: More…
