Stock Market Fluctuations and the Business Cycle
Posted: 23 Oct 2001
This paper examines the dynamic relationship between stock market movements and business cycles at the monthly frequency. Given the forward-looking behavior of stock market investors, it explores the possibility of using fluctuations in the stock market to forecast business cycle turning points using promptly available financial variables. The model generates predictions of business cycle turning points, using economic variables, and anticipation of these predicted turns, using financial variables. The empirical analysis is divided in two parts: first, it studies the historical track record of the interaction between the stock market indicator, the business cycle indicator, and the NBER-dated recessions. From this analysis, it is found that bear markets are closely associated with low-growth phases and economic recessions. Second, it implements an out-of-sample real time analysis of the performance of the stock market indicator in predicting economic recessions. The recursive real time forecasting performance of the stock market indicator is compared with the unrevised Composite Leading Indicator (CLI), computed by the Conference Board. The proposed indicator presents several advantages over the CLI. First, the financial indicator is less noisy than the CLI, which makes it easier to use it as a tool for anticipating turning points. Second, since financial market participants continuously update their expectations about the state of the economy as new information becomes available on a daily basis, over the course of the month movements in the financial indicator reflect revisions in these market perceptions. That is, the indicator can be computed at the end of each month reflecting updated information for that month. The unrevised CLI is also released at the end of the month, but it reflects information from the previous month. In addition, revisions are incorporated in the CLI index with a much lower frequency. Third, even though the CLI contains stock prices as one of its components, predictions of turning points using the stock market factor lead predictions using the unrevised CLI. Thus, the stock market indicator extracted from the model is a leading indicator of the state of the business cycle, and has been shown to be an effective tool to anticipate economic turning points in real time.
Note: This is a description of the paper and is not the actual abstract.
Keywords: Business Cycle, Stock Market, Dynamic Factor, Markov Switching
JEL Classification: C32, E32, E44
Suggested Citation: Suggested Citation