Relationship between Stock Market Prices and Macroeconomic Variables - Essay Example

Relationship between Stock Market Prices and Macroeconomic Variables ITRODUCTION Stock indices are normally used by investors and portfolio managers to make comparisons on investment option and to derive the general trend of the market. While it remains a purely mathematical formula, the index which is majorly derived from the prices of stock in capital markets can offer an incisive evaluation to the dynamics of economic variables. This means that the different variables of a particular macro economy are inextricably linked to the stock prices which are the major component of calculating the market index. The S& P 500 index for instance covers about seventy percent of the market capitalization. This is an indication that the indexes will rely majorly on the stock prices of the major companies in the capital market. Therefore most financial experts like relying on this index as it is closer to representing the real market. According to Madura (2008, pg 347), the index is calculated by considering the stock price of five hundred biggest companies in the market. It explains that the companies are selected based on their market capitalization. To understand this dynamic relation the relation between the stock price and the variables in macro economy, a clear and incisive analysis of the effects of these variables on the financial markets is required. This paper examines some of the relationships between the stock prices and market indices and the variables of macroeconomic environment within economies of countries like the United States and England. Gross domestic product The GDP of a nation covers all the products and services produced in a single financial year. In Berezina (2012) opinion, it covers the entire products, from the smallest item to the largest possible item and services purchased by the consumers in this economy. It notes that investors pay keen attention to indicators of sustainable growth in the GDP of an economy to make decisions on investment. When the report shows that there is growth in GDP, many investors will be attracted to the economy. This translates to higher stock prices as investors rush to acquire stakes in companies within these economies. In the absence of growth, the investor confidence is low and the stock prices are likely to slump. This is usually reflected in the performance of the index of the market. Analysts believe that the performance of a market over a financial year will reflect the overall performance in GDP. For instance Madura (2008) explains that economic factors that affect the stock prices include indicators like GDP (Madura 2008, pg 270). As been observed over the years a steady growth of GDP of Britain rose steadily from 200 to 2007 (yahoo finance). In comparison the stock prices of the major holdings did perform fairly well over the same period. This can be mainly attributed to investor confidence over the same period. Inflation It is expected that the general price of commodities will shoot up if an economy is experiencing inflation. This may not be the case with the stock prices in the same economy. According to Hall (2009) , the reaction of the prices will be in two faces. First the prices are expected to reduce substantially. This is due to the fact that Inflation lowers returns that an investor gets from their portfolios. For instance when there is a total of ten percent increase in inflation, any investor who earns or receives an increase I returns of about ten percent will have nil net increase on returns in the long run. This explains the drop in share prices at the initial stages of inflation. The effect of which is a loss should the investor opt to sell their stock at this stage. It should be noted that in the long run the share prices will eventually increase with all the other prices of commodities in this market. Economists believe that in order to mitigate the effect of inflation the government should cut some of the marginal taxes to reduce inflation (Wessel 2012, p245). Interest rates and government monetary policy Economists closely link inflation to the interest rates offered in the economy. According to (Robinson, 2013, pg 28), when a state controls the interest rates, the access to credit will be limited. This implies that the amount of money in the market is effectively controlled. When the cost of credit is low, the money available for investment will increase and this might result in higher prices of stock in these markets. This expansionary tactic has been used by governments to increase employment during a recession (Carr, Mayer and Cochran, 2011, pg 85). In the case where the company operates in a diverse environment like in the case of international companies, the use of strategic alliance can help the company mitigate the effects of different government policies enacted at the environments where they are operating subsidiaries. The effect of the alliances will mean that the company stock prices remain fairly stable and cushioned from adverse and hostile international business practices like excessive taxation. According to Sharman (2011), a carefully planned strategic alliance will assist the international company effectively enter into a new market during expansion and also reduce the risk of double taxation by the two countries it is operating in. This implies profitability and subsequent reflection on the share price at dividend pay out. If the company does not plan a proper way of handling the varied government policies, the end result will be loss of potential revenue to the government which will cause its stocks to go down. Currency Currency complications normally affect listed international companies. For instance according to Grossman and Livingstone (2001, pg 403), the growth of sales of an international company will be affected by currency fluctuations. This means that depending on the current trend of the currency market the company may record a loss or achieve revenue based on the prevailing international currency rates. To exploit the dynamic nature of the currency market, an international company should strategies to achieve an absolute cost advantage in its production (Mankiw 2014, pg 59). This can be achieved by strategic partnerships that will make the company acquire the factors of production at a cheap price and market its products in an environment with stronger currencies. When a company achieves constant growth in profitability levels, the payment of dividends will make potential investors interested in the stocks of the company. This has the effect of increasing the stock prices of the company. Owing to the fact that international companies have a larger share of the market capitalization, this will have a more profound bearing on the indices of the markets indices especially like S&P 500 which are calculated by market capitalization (imperial 2005). Employment and capacity utilization rate In an attempt to reduce unemployment, the government may decide to boost investment by initiating development projects. Such direct investments in the economy have long term effects on capacity utilization in a country. Laffer and Canto (1990), explain that when capacity utilization falls, the pressure of inflation on the economy is grossly reduced. It suggests that the implication is that the increase in capacity utilization will automatically translate to higher prices of commodities due to inflation. Applying this concept to determination of stock prices, the capital market will respond to capacity utilization in the same manner as it does to inflation. This means that when capacity utilization falls, the stock prices are likely to go up; conversely an increase in capacity utilization will fire up inflation which the market will react to by first lowering the prices before shooting up due to inflation. Government deficits have the effect of increasing interest rates and subsequent inflation due to high interest rates. One way of reducing deficits in government budgets is by creating employment opportunities. This will in turn spark an increase in tax collection and reduce the amount the government is willing to borrow locally. it should be noted that when a government has to fund the deficits through borrowing it will offer higher interest to attract investors. This has the net effect of putting more money in the hands of potential investors and the general public. The impact of which is a potential cause of inflation. Sentiment When market sentiment is carefully derived by the experts, the investor will be accordingly advised to either invest in a particular stock or not. Depending on whether the investors wish to invest or not, the effect on a market can either be bullish or bearish sentiments respectively. A bullish market sentiment will cause the identified stock prices to increase. Shefrin (2008) explains that this is due to the fact that investors expect the stock to perform well over a period of time defined in the sentiment projection. Usually the best performance of a stock is influenced by a number of activities that the current holding is undertaking and market forces. For instance a company doing an initial public offer may have higher stock prices since the demand for its stock by new investors could be high at that time. In order to effectively capture the market sentiment, the experts need to critically examine the historical data of the stocks in the market to derive a generally acceptable trend. Brown (1999), in analyzing capital markets, identified a special group of traders which are referred to as noise traders. It explained that the group will have a peer like influence on fellow traders when dealing with market sentiment. The effect of their activities is an increase in the stock prices (Brown, and Reilly, 2011). Saettelle (2012) acknowledges that market sentiment requires information retrieved over a reasonable period of time and variable sources. It stresses on the idea that this information has to be subjected to analysis by experts and specialized tools in order to effectively device the trends. It should be noted that the information is subject to the opinion of the portfolio manager or the financial expert. Conclusion Market indices are strong indicators of the future of economic environment that these markets are found. A careful analysis of the data of indices will reveal the general trend of impact of the various variables on the economy. From this analysis of the variables in macro-economic environment, it is clear that the dynamics of the economy have a bearing on the stock prices. This also effectively implies that the variables have an indirect bearing on the market indices which are calculated based on the stock prices. While examining the performance of the market indices, one should identify the possible causes of the performance which could be a combination of variables in the environment. Attention should be given to the probable causes and not to overlook other causes. This then will enable the expert to uncover the possible performance of the economy more accurately. The performance of Wall Street index for instance by extension will project the performance of economic variables in the United States economy. However, appreciating the fact that indices only represent a portion of the market, it may not be conclusively used to interpret the actual trend of economic activities. It should also be noted that listed international companies in the market have a diverse operating environments with regulation ranging from different governments and economic zones. This implies that the performance of their stock will not represent the economic situation in the trading environment but rather a global outlook of their macro economy. This explains the reason why the Wall Street indices have been able to predict all of the economic recessions of recent times. Reference list Brezina, C. 2012. Understanding the Gross Domestic Product and the Gross National Product. New York; The Roseben Publishing Group. Brown, k. and Reilly, F. 2011. Investment Analysis And Portfolio Management. New York; Carr, T., mayer, L. and Cochran, C. 2011. American public Policy. Hall, R. 2011. Inflation causes and effects. Chicago; Chicago University press IMF. Imperial, R. 2005. How to make big reurns from investing in small companies. New Jersey; john willey and sons. Jones, M. 2009, internationalization, enterpruership and the smaller firm. Northampton; Edward Elgar Publishing. Laffer, A. and Canto, V. 1990. Monetary Policy, Taxation, And International Investment Strategy; New York. Quorum books. Madura, j. 2008. Financial institutions and markets. Canada; cengage learning. Mankiw, N. 2014. Principles of economics.Canada; Cengage Learning Wessels, W. 2012. Economics. New York; Barons Education Series. Yahoo finance. Saettelle, J. 2012. Sentiment in the Forex market.indicaters and strategies. New Jersey; John Wiley And Sons. Shefrin, H. 2008. A Behavioral Approach to Asset Pricing. Carlifornia; Elservier Printing Press Sharman, A. 2011. Franchising and licensing; two powerful ways to grow your business in any economy. New York; Amacom publishers. World bank Read More