Final Work - Financial Econometrics - 2010

Financial Econometrics
21st of December 2010
Long run relationship between monetary policies and stocks market

in US from 1984 to 2010
Faculdade de Economia
Universidade NOVA de Lisboa
Professor Pablo Rodrigues
Christian Narvaez Henrique Almeida

MST16000283 MST16000347
21sr of December 2010
I
Table of contents
1. INTRODUCTION .................................................................................................................III
2. LITERATURE REVIEW…………………………………………………………………………………….………………….V
2.1. Monetary Policy and Stock Market…………………………………………………………..………………V
2.2. Efficiency Market Hypothesis (EMH)..……………………………………………………………..………VI
3. EVOLUTION OF THE FACTORS .......................................................................................... VII
3.1. Money Supply………………………………………………………………………………………………………....VII
3.2. Market (S&P 500)………………………………………………………………………………………………..….VIII
4. ECONOMETRIC ANALYSIS......................................................................................................XI
5. CONCLUSIONS………………………………………………………………………………………………………..………XIV
6. APPENDIX............................................................................................................................XVI
II
1. INTRODUCTION
Along the years there have been several studies in different countries addressed to try to
explain how Monetary Policies can influence the behaviour of stocks in the market. Many of
these papers have concluded that the main variables that show closest relation or can
strongly affect the returns of the instruments held by public may be: money supply and
interest rates. Of course there are other important variables that contribute to the
explanation in the change, namely: exchange foreign rate, fiscal changes (taxes), public
budget, among others. For instance if the Central Bank decides to increase money supply,
this may lead to a purchase of financial assets due to the “excess” of money that agents face
up. Being even stronger if the increase in the level is higher than expected or if the agents
did not expect any increase at all, and consequently, increasing the demand will make
increase the prices.
However this might have some other effects, although going to the same direction. In this
case the increasing in money supply may also lead to a major demand on bonds, making
their prices to increase and reducing the interest rate. If the market reacts like that, bonds
would be less appeal and investors could decide to invest in more attractive substitutes
instruments.
On the other hand (keeping the same scenario), increasing money supply and decreasing
interest rate, may stimulate a higher investment expenses by the companies with large
effects in the daily activity of them, leading to a better productivity, which can end up in
better outcomes (profits). If this scenario comes true, the prices of the stock in the market
will increase its price making it more appeal for investors.
Having these possible observations in the market, this paper is addressed to use the
econometric tools to try to explain the existing relation between monetary policies (money
supply), and the market index (for our case we have chosen S&P 500). We have decided to
work with money supply in our model, because we think that this particular monetary policy
is the most influential regarding the changes in the stock market returns (or putting in
another way: the changes in the stock market could be better explained through this
III
policies). But we are not ignoring the capacity to explain that other variables may have to get
the same conclusions.
To establish and order, first we expose some theoretical aspects that may be useful to take
into account. Second we will show the behaviour of the chosen indicators (money supply
and market index) along the time. Then we will try to explain the relation between them and
if they match with the theory. And finally we will end up with some conclusions about the
findings.
IV
2. LITERATURE REVIEW
2.1. Monetary policy and Stock market
There has been a long discussion and research around the relationship between these
two variables and the possible ways in which the outcome from these researches can be
used in order to forecast future behaviours and get desirables returns in the portfolios,
by using the information available. Although still is quite difficult to predict returns in the
market, the papers made, regarding this area, have been useful to establish the existing
relation between monetary policies and prices. Through them has been possible to state
that in effect unexpected increases or decreases in the money supply (for instance),
actually modify the equilibrium of the money regarding other assets in the investor’s
portfolio, who try to adjust it by changing the proportions on each element. Therefore,
all investors can do the same, readjusting what they need, but the system has to keep
the equilibrium by changing the prices. This is needed due to investor’s asset portfolio is
highly composed by financial stocks, so it is expected that the change in the money
supply will produce a change in the investor’s portfolio, being the reaction of the
investors quick or not, whereas the effect in the prices will be immediate.
All this is supported by the fact through the idea that for the average level prices of the
stock to be positive correlated with the money supply, it must be seen that the monetary
growth rate is positively related with the level and growth rate of the dividends and
negatively with the interest rate and risk premium. So, the influence of the money supply
over dividends works through the expected profits. Given the money demand, a
decrease on the level of supply would translate in an increase on interest rates and
reducing the expenses linked to the evolution of it (e.g. investments), consequently
generating reduction in the profits of the companies. The time in which decrease in
profits is connected to dividends depend on several characteristics of the company, but
is clear that stock prices will decrease if the dividends are reduced.
Some literature, regarding the previous scenarios, conclude that the influence of the
money supply over the risk component of the investor’s discount rate is a direct function
V
of the effect of supply over the market interest rate, however this relation is quite
difficult to quantify.
2.2. Efficiency Market Hypothesis (EMH)
This is another important issue that must be taken into account, given assumptions
stated and the relevance that brings when we are trying to understand and compare the
behaviour on prices by changes on other factors. The EMH suggest that at any given
time, prices fully reflect all the information available on a given stock or for the market in
general. This takes us to understand and assume that no investor can take advantage on
some different information (not available) to predict future movements on prices and
profit out of that obtaining abnormal returns.
This means that prices follows a random path (random walk) that make especially
difficult to forecast them. This also makes complex the job for investors due to the fact
that a planned approach to invest would not be successful if we recognize this random
walk.
On the other hand, accepting the EMH in its purest form may be difficult. The efficiency
of capital markets is among the main problems of the financial sector’s development. In
the economics literature, there are three forms of efficiency: weak, semi-strong and
strong.
1. Strong efficiency – This is the strongest form, which states that all information in a
market, whether public or private, is accounted for in a stock price. Not even insider
information could give an investor an advantage.
2. Semi-strong efficiency – This type of EMH implies that all public information is
calculated into a stock's current share price. Neither fundamental nor technical analysis
can be used to reach superior gains.
VI
3. Weak efficiency – This version of EMH claims that all past prices of a stock are
reflected in today's stock price. Therefore, technical analysis cannot be used to predict
and beat a market
From this framework, in which we consider the expected impact of money policies, (e.g.
money supply and interest rates), over the market prices, and the assumptions stated in
the Efficiency market Hypothesis, we will try to explain and conclude whether in fact
those theoretical bases match with the observable behaviour, and whether it can be
explained through regressions processes.
3. EVOLUTION OF THE FACTORS
As we have mentioned before, the variables we will use for this case to explain
changes in stock prices are: money supply (M1) and interest rates (i). In order to go a
little bit deeper on the variables, we want to show in graphics the path followed for
each one (and in the case of M1, the changes on some of its components) and
explain some details about them and the reasons of this behaviour.
3.1. Money Supply
For this variable we have that, it is determined through the following formula: M1=
m*(MBn + Br). For simplicity we will just talk about this components in the way that
it is presented in the formula, avoiding go into deeper details (i.e. avoid deriving each
component and find every single factor affecting them).
For this case we can see in the graphics that M1 show an increasing path through the
years. Considering some papers talking about it and the knowledge of
Macroeconomics, we know that M1 can be affected for factors like: currency ratio,
reserves, excess reserve ratio, borrowed and non-borrowed monetary base. Along
the years the behaviour seems to show a constant but not so sharp growth, just
being abnormal in 2.008 due to the crisis period. It is said that during this time, the
excess Reserve Ratio and Borrowed Monetary Base increased considerably due to the
VII
measures implemented to ensure the stability of banks through money supply

policies. It was needed to keep safe the system but increasing the volume of money
in the market and also increasing the required level of reserves in the banks, in order
to cover the obligations and have a safety “mattress” for short term effects.
Money supply
2000,000
1800,000
1600,000
1400,000
1200,000
1000,000
800,000
600,000 Money supply
400,000
200,000
0,000
3.2. Market (S&P 500)
Regarding the movement in the market, we should use the money supply to try to
explain the behaviour, because by itself it would not have so much to say. As we can
notice (figure below) the market follow a close trend along the years similar to money
supply, till 1.997 where the market began to show peaked growth, higher that money
supply. But going down again after 2.000, and maintaining the same trend with M1. Then
with the financial crisis, market suffered a dramatic drop in the index, which still have
effects in some economies. Thus, we have observed two important periods along the
time that deserve to be considered and understood.
In 1997, the economy was strong and the money supply had growth strongly in past
years and kept the tendency over the next years. This was accompanied by a strong
dollar, firm commodities stable inflation and interest rates (showing a decreasing
VIII
behaviour in the last one). By 1998 sales of the industry began to growth faster than the
previous year as a signal of the strength of the economy based on the monetary policies
(i.e. money supply and interest rates).
By 1.999 the economy reached its highest point, the indexes went up from 1.998 and
kept rising in 1.999 till get record levels. Companies were selling more than the
inventories, reflecting so high rate of production.
The credit spread declined from the high levels reached in 1998, suggesting that credit
conditions were becoming normal again. This spreads in fact decline to the lower end of
their historical range. Financial risk was well above average after 2000, creating a
background of uncertainty for the financial markets.
Now, regarding the second crucial point of the line-time, during the crisis (started in the
middle of 2.008), we can observe the deepest drop on the index prices (for the period of
time we are considering). The crash in the financial system, the loss in the confidence,
the uncertainty about the future and the weaknesses in the system, caused the
companies to lose or reduce heavily their sales and their productiveness. It was
supported by the continuous selling attack of stocks by investors leading to a general
decrease on prices. Thus, the central bank and the government should make intervention
buying companies and issuing money as the main strategy to reactivate and stabilize the
economy and minimize the negative impact.
IX
2000
1800
1600
1400
1200
1000
800 Money Supply
600 S&P 500
400
200
0
X
4. ECONOMETRIC ANALYSIS
In first step we run the following regression, in order to analyze the relationship between
the S&P index returns and the Money Supply.
Therefore we obtain the following results from the regressions:
Variable Coefficient Std. Error t-Statistic Prob.
0.064359 1.680090 0.038307 0.9697
C 0.017131 0.014888 1.150641 0.2608
Furthermore, using these results we made the Augment Dickey Fuller test for the residuals,
in order to conclude whether it is stationary or not. On this test we obtained that the
Augmented Dickey Fuller test statistic is -5,052480, which means that the residuals are
stationary.
As the residuals are stationary we can run the following regression in order to achieve the
co-integration vector:
The results were the following ones:
S&P 1.001997 0.018368 54.55124 0.0000
0.022928 0.154304 0.148587 0.8831
XI
C -0.000867 0.001403 -0.618222 0.5423
Thus, we achieve the co-integration vector [1.001997 ; 0,022928 ; -0,000867].
In cases of cointegration, we know that the changes on the dependent variable could be
explained by its own past changes, and by changes in independent variables.
On this case our dependent variable is going to be the changes in S&P index returns, and the
dependents variables are going to be: S&P index in returns in period t-1, money supply and
money supply in period t-1.
From this regression we obtained the following results
(
0,488476354 7,32E-18 6,66E+16 0
(
-1,28391E-14 2,75E-15 -4,66184 4,62E-06
(
1,28991E-14 2,75E-15 4,690375 4,06E-06
C 0,009065144 1,357E-17 6,68E+14 0
If we subtract both sides by , add and subtract RHS by we can finally achieve
the relationship between S&P returns and money supply.
XII
We can interpret the terms in levels as the long-run
component, and terms in first difference as the short-run component.
If we write again the equation above, we can derive the Error-Correction Model:
In this case, may be seen as the short-run multiplier, which measures the impact of a
change on over the changes on S&P, and as the long term multiplier, which
measures the impact on the levels of S&P of changes in . Moreover, ( ) is the speed
of adjustment term, measuring how fast will the variables adjust to the equilibrium
cointegrating relationship.
XIII
5. CONCLUSIONS
The main goal of this exercise is to proof whether there is a relation between changes in
monetary policies (Money supply, M1) and the prices in the Stock Market. In this sense we
have seen the importance that has the liquidity of the economy as a player determining the
prices in the market (taking into account the market index S&P500). In effect we can say that
the sales level of the companies and their profits are affected by the decisions of the amount
of money circulating (also by interest rates and other factors, but for this case we just used
M1). Putting it in other way, if the money supply in the economy increases (saying that the
interest rates are at an accepted level that encourage investments), this would translate in a
higher level of PPP (purchase parity power) of the agents in the economy. In this case, the
agents have higher amount of money to consume good/services from the companies, which
will increase their sales and consequently the profits, due to a larger spread between costs
and revenues1. If the companies increase sales and profits, their value (price) will increase as
well in response to a better realized (in the present) and expected (future) cash flows.
In addition to this effect, if money supply increases, investors will be more willing to invest in
stock, bonds or any other instrument that offer better returns than savings. This would push
up the prices of the stocks through the effect of a higher demand (if investors decide to
invest mainly on them) for these instruments.
Nevertheless, we know that is required to make this same analysis by using more
explanatory variables, namely: interest rates, exchange interest rates, reserves level, among
others, in order to explain better the effect of more monetary policies on prices.
Finally, in crisis periods (e.g. period after June of 2.008) is more difficult to test cointegration
given the special characteristics of the market during this weak and uncertainty scenario.
The agents in the economy are prevented and distrustful about the future reaction of the
1
This does not say that the spread will be larger per se. We know that Variable Costs will increase with the
sales (in a lower level, but they will increase), due to the needs of supplies to satisfy the higher demand. But on
the other hand, the Fixed Cost will not increase a the same level, due to the fact that they are almost
uncorrelated with changes in sales.
XIV
companies and economy, which makes that the actions taken to stabilize the path show a
slow effect or an effect that would be faster or stronger in other circumstances.
XV
6. APPENDIX
Regressions and tests
Dependent Variable: SP
Method: Least Squares
Date: 12/21/10 Time: 16:04
Sample: 1984 2010
Included observations : 27
M1 0.064359 1.680090 0.038307 0.9697

C 0.017131 0.014888 1.150641 0.2608
R-squared 0.000059 Mean dependent var 0.017626

Adjusted R-s quared -0.039939 S.D. dependent var 0.037571
S.E. of regression 0.038314 Akaike info criterion -3.614804
Sum squared resid 0.036699 Schwarz criterion -3.518816
Log likelihood 50.79986 F-statistic 0.001467
Durbin-Watson stat 2.063141 Prob(F-statistic) 0.969747
Dependent Variable: SP
Date: 12/21/10 Time: 16:01
Sample: 1984 2010
Included observations: 27
M1 2.77E-10 5.90E-11 4.690203 0.0001

PASTM -2.76E-10 5.89E-11 -4.690223 0.0001
SPPAST 0.488476 7.18E-12 6.80E+10 0.0000
UPAST -3.38E-11 7.21E-12 -4.690855 0.0001
C 0.009065 2.91E-13 3.12E+10 0.0000

Adjusted R-squared 1.000000 S.D. dependent var 0.037571
S.E. of regress ion 3.72E-15 Sum squared resid 3.04E-28
F-statistic 6.64E+26 Durbin-Watson stat 2.061181
Prob(F-statis tic) 0.000000
XVI
Dependent Variable: U
Date: 12/21/10 Time: 16:05
Sample: 1984 2010
Included observations : 27
SP 1.001997 0.018368 54.55124 0.0000

M1 0.022928 0.154304 0.148587 0.8831
C -0.000867 0.001403 -0.618222 0.5423

Adjusted R-s quared 0.991334 S.D. dependent var 0.037799
Cointegration vector [ 1,001997 ; 0,022928 ; -0,000867]
XVII
Null Hypothesis: U has a unit root

Exogenous: Constant
Lag Length: 0 (Automatic based on SIC, MAXLAG=6)
t-Statistic Prob.*
Augmented Dickey-Fuller test statistic -5.052480 0.0004

Test critical values : 1% level -3.711457
5% level -2.981038
10% level -2.629906
*MacKinnon (1996) one-sided p-values.
Augmented Dickey-Fuller Test Equation

Dependent Variable: D(U)
Date: 12/21/10 Time: 16:06
Sample (adjusted): 1985 2010
Included observations: 26 after adjustments
U(-1) -1.040315 0.205902 -5.052480 0.0000

C 0.018413 0.008315 2.214458 0.0365

Adjusted R-squared 0.495230 S.D. dependent var 0.054987
XVIII
Null Hypothesis: M1 has a unit root

Exogenous: Constant
t-Statistic Prob.*
Augmented Dickey-Fuller test statis tic -3.054619 0.0429

5% level -2.981038
10% level -2.629906

Dependent Variable: D(M1)
Date: 12/21/10 Time: 16:07
Included observations : 26 after adjustments
M1(-1) -0.623305 0.204053 -3.054619 0.0054

C 0.004938 0.001734 2.848425 0.0089

XIX
Null Hypothesis: SP has a unit root

Exogenous: Constant
t-Statistic Prob.*
Augmented Dickey-Fuller test statis tic -5.059075 0.0004

5% level -2.981038
10% level -2.629906

Dependent Variable: D(SP)
Date: 12/21/10 Time: 16:07
Included observations : 26 after adjustments
SP(-1) -1.047182 0.206991 -5.059075 0.0000

C 0.018558 0.008375 2.215742 0.0364

XX
Graphics
.12
.08
.04
.00
-.04
-.08
84 86 88 90 92 94 96 98 00 02 04 06 08 10
M1 SP
.25
.20
.15
.10
.05
.00
-.05
-.10
-.15
84 86 88 90 92 94 96 98 00 02 04 06 08 10
SP SPPAST
XXI
.25
.20
.15
.10
.05
.00
-.05
-.10
-.15
84 86 88 90 92 94 96 98 00 02 04 06 08 10
U UPAST
XXII

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Financial Econometrics

21st of December 2010

Long run relationship between monetary policies and stocks market

Christian Narvaez Henrique Almeida

21sr of December 2010

21st of December 2010

2.1. Monetary Policy and Stock Market…………………………………………………………..………………V

2.2. Efficiency Market Hypothesis (EMH)..……………………………………………………………..………VI

3. EVOLUTION OF THE FACTORS .......................................................................................... VII

3.1. Money Supply………………………………………………………………………………………………………....VII

3.2. Market (S&P 500)………………………………………………………………………………………………..….VIII

21st of December 2010

21st of December 2010

21st of December 2010

2.1. Monetary policy and Stock market

21st of December 2010

2.2. Efficiency Market Hypothesis (EMH)

21st of December 2010

3. EVOLUTION OF THE FACTORS

3.1. Money Supply

21st of December 2010

measures implemented to ensure the stability of banks through money supply

3.2. Market (S&P 500)

21st of December 2010

21st of December 2010

21st of December 2010

Therefore we obtain the following results from the regressions:

Variable Coefficient Std. Error t-Statistic Prob.

0.064359 1.680090 0.038307 0.9697

C 0.017131 0.014888 1.150641 0.2608

The results were the following ones:

Variable Coefficient Std. Error t-Statistic Prob.

S&P 1.001997 0.018368 54.55124 0.0000

0.022928 0.154304 0.148587 0.8831

21st of December 2010

C -0.000867 0.001403 -0.618222 0.5423

Thus, we achieve the co-integration vector [1.001997 ; 0,022928 ; -0,000867].

From this regression we obtained the following results

Variable Coefficient Std. Error t-Statistic Prob.

C 0,009065144 1,357E-17 6,68E+14 0

the relationship between S&P returns and money supply.

21st of December 2010

We can interpret the terms in levels as the long-run

component, and terms in first difference as the short-run component.

21st of December 2010

21st of December 2010

21st of December 2010

Regressions and tests

Variable Coefficient Std. Error t-Statistic Prob.

M1 0.064359 1.680090 0.038307 0.9697

R-squared 0.000059 Mean dependent var 0.017626

Variable Coefficient Std. Error t-Statistic Prob.

M1 2.77E-10 5.90E-11 4.690203 0.0001

R-squared 1.000000 Mean dependent var 0.017626

21st of December 2010

Variable Coefficient Std. Error t-Statistic Prob.

SP 1.001997 0.018368 54.55124 0.0000

R-squared 0.992000 Mean dependent var 0.016971

Cointegration vector [ 1,001997 ; 0,022928 ; -0,000867]

21st of December 2010

Null Hypothesis: U has a unit root

Augmented Dickey-Fuller test statistic -5.052480 0.0004

*MacKinnon (1996) one-sided p-values.