Business Cycles, Macro Variables, and Stock Market Returns
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Transcript Business Cycles, Macro Variables, and Stock Market Returns
Business Cycles, Macro
Variables, and Stock Market
Returns
William Carter, David Nawrocki,
and Tonis Vaga
Agenda
Introduction and literature review (Jon)
Relationships between real activity and
stock returns (Jordan)
Multiple phases of the business cycle
(Danielle)
Linear regression analysis (Dmitry)
Application of neural network (Raegen)
Conclusion (Jon)
Introduction
Business cycle indicators: relevant issue
Chen, Roll, and Ross; Fama and French; and
Schwert
Risk premium embedded in expected returns
moves inversely with business conditions
Whitelaw
Conditional returns and conditional volatility
change over time with changes in the cycle
Nawrocki and Chauvet
Find dynamic relationship between stock market
fluctuations and cycles
Intro. Con’t.
Perez-Quiros and Timmerman
Asymmetries in conditional mean and volatility of
excess stock returns around cycle turning points
Chauvet and Porter
Suggest non-linear risk measure that allows riskreturn relationship to not be constant over Markov
states
DeStafano
Tests four-state model of cycle and dividend
discount model to provide evidence that expected
stock returns vary inversely with economic
conditions
This all suggests…
Nonlinear financial market dynamic
Thus requiring a nonlinear methodology
Between business cycle and stock market
DeStafano (2004)
Arbitrarily defined four phases
Period between NBER peaks and troughs into two
equal periods
Where the authors differ
Utilizes simple linear models
Looks for phase transitions
Provides preliminary definitions of phases
Then used in the neural network methodology for final
estimates of the phases
Independent of NBER peaks and troughs
Not announced until 9-18 months after the
fact
Multiple Phases of the Business
Cycle
Chauvet and Potter (1998) and Perez-Quiros and
Timmermann (2000) study two phases: expansions and
recessions
Consistent with the NBER’s definition of business cycle peaks
and troughs
Chauvet and Potter (1998) note changes in conditional
means and variances well before the peak and trough,
suggesting additional phases of the business cycle
Four/five-stage models have been proposed by Hunt
(1987), Stovall (1996), DeStefano (2004), Guidolin and
Timmermann (2005), Guidolin and Ono (2006)
Advantages of the Neural Network
Eliminates problems from traditional
approaches
Linearity assumptions
Data-pooling issues
Data mining
Pre-specification of the model
Relationships between Real Activity
and Stock Returns
Prior Research:
Moore (1976) and Sherman (1986) found certain economic
indicators are leading indicators for the business cycle and
security markets
Chen, Roll, Ross (1986) modeled equity returns using
macroeconomic factors:
Industrial Production
Monetary Aggregates
Debt Market Yields
Fama & French (1989) measured stock return volatility using the
relationship between returns and real activity
Skewness
Skewness and volatility has also been tied to the
business cycle
Schwert (1989) finds stock market volatility increases
during recessions
Other research has found high variability in the
skewness of stock returns and that it varies
systematically with business conditions
Skewness becomes more negative during expansions
and less negative or positive during contractions
Prior Research
Whitelaw (1994) finds that the relationship
between the conditional mean and volatility of
stock returns is nonstationary
Using a linear relationship between mean and
volatility can lead to incorrect results from GARCH
and ARCH models
Utilizing a Nonlinear Markov switching
regression:
Volatility increases during recessions
Conditional means rise before the end of recessions
Conditional means decrease before the peak of
expansions
Sharpe ratios are negative in troughs, positive in
peaks
Prior Research
Whitelaw (1994) et al. find conditional variance is
countercyclical
Fama and French (1989) et al. find conditional means
move with the business cycle
Rapach (2001) finds real stock returns are related to
changes in money supply, aggregate supply, aggregate
spending
This research suggests that stock market phases are
related to economic fluctuations
Prior Research
Recent research finds that the power of the
economic factors used for predictions varies
over time and volatility
Small firms are shown to be strongly affected
during recessions
Fundamental factors such as DDM are affected
by the business cycle
Investors discount earnings using short term T-Bill
when the economy is slowing down
Discount using long term T-Bond rate in the other
states of economy
Method
Time-invariant forecasting models will not work under
sudden large changes in time series
Previous research was determined using the NBER
cycle dates, which have a lag of 9 – 18 months
The Markov switching VAR is used in this study along
with a neural network
It does not require the form of the regression to be previously
specified
Allows for a state switching nonlinear model that tests
the significance of the various macroeconomic variables
The neural network must be provided with an initial set of dates
for the phases and macroeconomic variables for the transistions
Multiple Phases of the Business
Cycle
Chauvet and Potter (1998) and Perez-Quiros and
Timmermann (2000) study two phases: expansions and
recessions
Consistent with the NBER’s definition of business cycle peaks
and troughs
Chauvet and Potter (1998) note changes in conditional
means and variances well before the peak and trough,
suggesting additional phases of the business cycle
Four/five-stage models have been proposed by Hunt
(1987), Stovall (1996), DeStefano (2004), Guidolin and
Timmermann (2005), Guidolin and Ono (2006)
Stovall’s Business Cycle Phases
Expansion in 3 phases:
Recovery from recession – slow growth
Economic growth picks up vigorously
Inflation increases
Recession in 2 phases:
Decline in economic production
Economy flattens out and begins to recover
A simplistic model – Stovall uses the time period
between NBER peaks and troughs, divides each time
period evenly into three and two periods
Finds that certain sectors perform well during certain
stages
Hunt’s Business Cycle Phases
Hunt suggests economic variables that drive the transition between phases
Easeoff
Industrial production slows
Initial unemployment claims increase
Non-farm payrolls turn down
University of Michigan Consumer Sentiment index falls
Plunge
Federal Funds rate decreases
Real monetary base increases
Interest rate spread narrows
Revival
Industrial production increases
Initial unemployment claims fall
Non-farm payrolls increase
Acceleration
Real monetary base increases
Consumer Price Index rises
Early Revival – transition between Plunge and Revival
Hunt’s Business Cycle Phases
Implemented his model using 12-month rate of change
statistics, followed monthly
One complete cycle measured from Easeoff to Easeoff
phase
Each phase exhibited different investment behavior
Easeoff had significant negative skewness
Consistent with Alles and Kling’s (1994) finding that skewness
becomes strongly negative during contractions
Plunge had insignificant skewness
Revival had initial insignificant skewness, followed by positive
significant skewness
Acceleration exhibited poor risk-return behavior (high inflation
period)
Easeoff and revival exhibited the best risk-return behavior
Linear regression analyses
Two regression analyses performed on monthly time
series for the period 1970-1997 to study relationships
between S&P 500 and variables
Macroeconomic variables considered
CPI rate of change (CPIROC)
Industrial production rate of change (IP)
Spread between 90-days T-bill and 30-year T note (SPREAD)
Difference between AAA and BAA corporate bonds (AAA_BAA)
Rate of change in real adjusted monetary base lagged 4 month
(REAL_MB)
Level of housing starts (STARTS)
Level of manufacturing orders excluding aircraft and parts
(ORDERS)
Regression results for 1971-1997
Industrial production, manufacturing orders, and housing starts are
significant at 10% confidence level
The correlation between independent variables is quite low below 0.40.
Only two correlation coefficients were as high as 0.60
Adjusted R2 below 0.0386 indicates little relationship between variables
Individual regression results for four
business cycle phases
Individual regression results for four
business cycle phases (cont.)
Impact of variables changes through the phases
of the business cycle
All of the phase regressions have higher
adjusted R2 compared to the base regression
The four phase regressions exhibit different
significant independent variables both from each
other and the base regression
Conclusion: strong support for the hypothesis
that S&P 500 has different phases
Studying Economic Phases with a
Neural Network
What is a neural network?
Mimics the structure of the brain. Output is produced
by interconnected nodes in a parallel fashion as
opposed to traditional sequential processing.
This operation makes the NN more robust and
adaptable to fuzzy logic.
Here, a neural network is used as computational
architecture to learn from past economic phases and
performance variables. And, then predict unseen
phases in the economy.
Studying Economic Phases with a
Neural Network
Advantages of using a Neural Network
Captures all relationships (linear and non)
A pre-specified regression equation is not required
This study uses a PNN
PNN’s use estimated “probability functions to train the
network with a data set.”
It is an adaptive PNN, meaning that an algorithm
determines a smoothing function for each variable.
The variables can be weighted and insignificant
variables eliminated.
Studying Economic Phases with a
Neural Network
Studying Economic Phases with a
Neural Network
How it works
The neural network was trained, using 1971 to 1988, to specify
the phase for the next year.
After each 12 month period was added on the network retrained
Testing the neural network
Known economic phases for Dec 1989 through Dec 1997 were
compared to the neural network’s defined phases
Linear and nonlinear models differ 37% of the time…indicating
that there is some nonlinear dynamic captured by the NN.
“There are significant variables and processes in the S&P data
stream that are not strictly linear. Linear models can only
approximate the actual nonlinear process.”
Studying Economic Phases with a
Neural Network
…Since 1997
Summary and Conclusions
Previous research
Two market states in economy and US stock
market returns (S&P 500 index)
Four, possibly five Markov states have been
identified in the business cycle
Regression analysis and neural network
provide evidence of four distinct market states
Supports empirical research that delineates 4-5
market states
Summary and Conclusion Con’t.
Instead of a fundamental variable
approach using earnings and discount
rates (DeStafano)
Macroeconomic variable approach was
used
Real time approach
Even though independent of NBER
NBER peak occurs in Easeoff/Plunge phases
NBER trough occurs in Plunge/Revival phases
Summary and Conclusion Con’t.
This methodology closely corresponds to the
“growth cycle” methodology defined by
Geoffrey H. Moore
Also supports studies that discovered
nonlinear relationships in financial markets
Chauvet and Potter (1998)
Perez-Quiros and Timmermann (2000)
Echo LeBaron’s warning
Results with nonlinear measures are not as robust
as results obtained from linear models
Step Back…..
These different business cycles could be
used for the Coleman Fund
To switch out of potentially underperforming
sectors
QInsight has the economy in the plunge
phase
In general, if these criteria were used we would be
invested in a slightly different combination of
sectors