Coincident and Leading Indicators of the Stock Market

Abstract

In this paper we have two goals: first, we want to represent monthly stock market fluctuations by constructing a nonlinear coincident financial indicator. The indicator is constructed as an unobservable factor whose first moment and conditional volatility are driven by a two state Markov variable. It can be interpreted as the investors' real time belief about the state of financial conditions. Second, we want to explore an approach in which investors may use their perceptions of the state of the economy to form forecasts of financial market conditions and possibly of excess returns. To investigate this, we build leading indicators as forecasts of the estimated coincident financial index. The leading indicators yield better within and out-of-sample performance in forecasting, not only the state of the stock market but also of excess stock returns, as compared with the performance obtained using linear methods that have been proposed in the existing literature.

JEL Classification: E44, G12