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    Economic Forces and the Stock Market Nai 'u Chen; Richard Roll; Stephen A. Ross The Journal of Business, Vol. 59, No. 3 (Jul., 1986), 383-403. Stable URL: Ittplinksstor.orgsici?sici=01021-9998°% 28 1986075%2059%3 A3%3C383%3ABFATSM@3B2.0,CO@IB2-L, ‘Your use of the ISTOR archive indicates your acceptance of ISTOR’s Terms and Conditions of Use, available at fp (fw. jstor orglaboutitersihtml. ISTOR's Terms and Conditions of Use provides, in part, that unless You. have obtained prior permission, you ray not download an entire issue of &joumal or multiple copies of aricies, and You may use content in the ISTOR archive only for your personal, non-commercial use. Each copy of any part of a JSTOR twansmission must contain the same copyright notice that appears on the sercen or lnted page of such transmission. The Journal of Business is published by The University of Chicago Press. Please contact the publisher for further permissions regarding dhe use of this work. Publisher contact information may be obtained at fpf jtororg/journalsfucpeess html ‘The Journal of Business (©1986 The University of Chicago Press ISTOR and the ISTOR logo are trademarks of ISTOR, and are Registered in the US. Patent and Trademase Office. For mote information on ISTOR contact jstor-info@umich edu, ©2003 IsTOR bup:thrwwjstor.orgy ‘Mon Sep 1.03:44:30 2003 Nai-Fu Chen Uhaversty of Chicago Richard Roll University of Calforia, Los Angeles Stephen A. Rass Yale Cniversty Economic Forces and the Stock Market* [Introduction Assct prices are commonly believed to react sen- sitively to economic news. Daily experience scems to support the view that individual asset prices ate influenced by 2 wide variety of unanticipated events and that same events have ‘a more pervasive effect on asset prices than do others. Consistent with the ability of investors to diversify, modern financial theory has focused ‘on pervasive, or “systematic,” influences as the likely source of investment risk.’ The general conclusion of theory is that an additional compo- nent of long-run return is required and obtained whenever 2 particular asset is influenced by sys- tematic economic news and that no extra reward can be earned by (needlessly) bearing diversifi- able risk. * The authors are grateful o their respestve universities, to the Center (or Research in Security Prices, 10 dhe National ‘Sclesice Foundation for research support, and to Ceajer Chan or computational assistance. The comments of Bradford Cornell, Eugene Fara, Perre Hillon, Richard Sweeney, and ‘Anthuy Warga vere most belpful, as were the comments of pittcipants in workshops at Claremont Graduate ‘School, Stanford University, the University of Toronto, the Univers sity of California, Irvine, the University of Alberta, the Uni- versity of Chicago, and Unknown referees. The University of British Columbia provided a sumulating research eaviron iment where part ofthe fst revision was wntten during Ate aus 1984 1, For example, the APT (Ross 1976) and the models of Merion (1973) and ox, Inger and Ros (989) Te eons Ken with this view ‘Journal of Business 1986, vo. $9, 00.3) © 1986 by The University of Chicago. All ghts reserved. ‘0021 939886/5903-000101. 50 ey ‘This paper tests whether tnnovations in ables ae risks that are rewarded in the stock ‘market. Financial Ahcory suggests that the following macro- economic variables ‘should systematically affect stack market returns: the spread between long and short iuerest rates, expected and unexpected ina- tion, industrial prodic~ tion, and the spread between high: and low rade bonds. We fad {hat these sources of ‘Hak are significantly priced, Furthermore, neither the market Portfolio nor agaregate Consumption are priced separately. We also fio that oi pice isk is not separately re- Warded in the stock market. a Joursal of Business The theory has been sileat, however, about which events are likely to influence all assets. A rather embarrassing gap exists between the theoretically exclusive importance of systematic “state variables” and ‘our complete ignorance of their identity. The comovements of asset prices suggest the presence of underlying exogenous influences, but we hhave not yet determined which economic variables, if any, are respon- sible Our paper is an exploration of this identification terrain. In Section TI, we employ a simple theoretical guide to help choose likely candi- dates for pervasive state variables, In Section III we intraduce the data and explain the techniques used to measure unanticipated movements in the proposed state variables. Section IV investigates whether expo- ‘sure to systematic state variables explains expected returns, As specific alternatives to the pricing influence of the state variables identified by our simple theoretical madel, Section IV considers the valuc- and the equally weighted market indices, an index of real con- sumption, and an index of oil prices. Each of these is found to be unimportant for pricing when compared with the identified economic state variables. Section V briefly summarizes our findings and suggests some directions for future research, I. Theory No satisfactory theory would argue that the relation between financial markets and the macroeconomy is entirely in one direction. However, stack prices are usually considered as responding to external forces (even though they may have a feedback on the ather variables). It is apparent that all economic variables are endogenous in some ultisate sense. Only natural forces, such as supemovas, earthquakes, and the like, are truly exogenous to the world economy, but t0 base an asset- pricing model on these systematic physical factors is well beyond our ‘current abilities. Our present goal is merely 10 model equity returns as functions of macro variables and nonequity asset returns. Hence this paper will take the stock market as endogenous, celative to other mar- eis, By the diversification argument that is implicit in capital market theory, only general economic state variables will ifluence the pricing of large stock market aggregates. Any systematic variables that affect the economy's pricing operator or that influence dividends would also influence stock market returns. Additionally, any variables that are necessary to complete the description of the state of nature will also be part of the description of the systematic risk factors. An example of such a variable would be one that has no direct influence on current cash flows but that does describe the changing jnvestment opportunity set. Economie Forces and the Stock Market as Stock prices can be written as expected discounted dividends: Ele) pe, oO where c is the dividend stream and & is the discount ratc. This implics that actual returns in any period are given by dpe ME dk, ic pp Be ke 2 It follows (trivially) that the systematic forces that influence returns are those that change discount factors, k, and expected cash flows, Ec). The discount rate is an average of rates over time, and it changes with both the level of rates and the term-structure spreads across dif- ferent maturities, Unanticipated changes in the riskless interest rate will therefore influence pricing, and, through their influence on the time value of future cash flows, they will influence returns. The discount rate also depends on the risk premium; hence, unanticipated changes in the premium will influence returns. On the demand side, changes in the indirect marginal utility of real wealth, perhaps as measured by real consumption changes, will influence pricing, and such effects should also show up as unanticipated changes in risk premia. Expected cash flows change because of both real and nominal, forces. Changes in the expected rate of inflation would influence nomi- ‘nal expected cash flows as well as the nominal rate of interest. To the extent that pricing i done in feal terms, unanticipated price-evel Changes will have a systematic effect, and to the extent that relative prizes change along with general inflation, there can also be a change in asset Valuation associated with changes in the average inflation rate. Finally, changes in the expected level of real productign would affect ‘the current real value of cash flows, Insofar as the risk-premium mea- sure does not capture industrial production uncertainty, innovations in the rate of productive activity should have an influence on stock re- turns through their impact on cash flows, TI. Constructing the Economic Factors Having proposed a set of relevant variables, we must now specify their measurement and obtain time series of unanticipated movements. We could proceed by identifying and estimating a vector autoregressive model in an attempt to use its residuals as the unanticipated innova- 2. Since we are only concerned with intuition, we are ignoring the second-order terms ‘rom the stochasti calculus in denving eq, (2). Also notice thatthe expectation i taken ‘with respect to the martinaale pricing measure (see Cax eal. 1988) and tot with respect (a the ordinary probability dstibuton 386 Fouenal of Business tions in the economic factors. It is, however, more interesting and (perhaps) robust out of sample to employ theory (o find single equa- tions that can be estimated directly. In particular, since monthly rates of return are nearly scrially uncorrelated, they can be employed as, innovations without alteration. The general impact of a failure ade- ‘quately to filter out the expected movement in an independent variable is to introduce an crrors-in-variables problem. This has to be traded off ‘against the crror introduced by misspecification of the estimated equa- tion for determining the expected movement. ‘A somewhat subtler version of the same problem arises with proce- dures such as vector autoregression. Any stich statistically based time- seties approach will find lagged stock market returns having a signifi- cant predictive content for macroeconomic variables. In the analysis of pricing, then, we will indirectly be using lagged stock market variables to explain the expected returns on portfolios of stocks. Whatever ‘econometric advantages such an approach might offer, itis antithetical to the spirit of this investigation, which is to explore the pricing in fluence of exogenous macroeconomic variables. For this reason, as much as for any other, we have chosen to follow the simpler route in constructing the time series we usc.* ‘Throughout this paper we adopt the convention that time subscripts apply to the end of the time period. The standard period is 1 month. ‘Thus, EC |r — 1) denotes the expectation operator at the end af month 1 = conditional on the information set available at the end of month ¢ = 1, and X() denotes the value of variable X in month r, or the growth that prevailed from the end of r — | to the end of ¢. A. Industrial Production ‘The basic series is the growth rate in U.S. industrial production. It was, obtained from the Survey of Current Business. If 1P(«) denotes the rate of industrial production in month ¢, then the montily growth rate is MP() = loge IP(r) — log, IPC — 0, GB) and the yearly growth rate is YP(t) = log. IPC) — loge IP(¢ — 12) a Gee table [ for a summary of variables). Because IPCs) actually is the flow of industrial production during ‘month 1, MP(2) measures the change in industrial production lagged by at least a partial month. To make this variable contemporaneous with ther series, subsequent statistical work will lead itby 1 month. Except for an annual scasonal, it is noisy enough to be treated as an in- ovation. 4, Tn addition, the pricing ests reported bolow used portfolios that have induced aulocarrelations in their veturms arising fom the nontiading effect, Fconomle Forces and the Stock Market aw TABLE 1 Glasary ad Delos of Varies Symbl Marable _—etniion ov See eaieseies 1 inde Lap ine oS, Conse Te tesa ate nds eed vt on son LGB Lasetermgovemment fonds Reto lames goverment ‘bonds (1958-78: Thbotsan and Singueeld 1982}; 1979-85 RSP) ie ‘Industral praducton Industral production during ‘month (Sursey of Current Basie ess} Pas Low-arade bonds Return on bonds rated Has and ‘under (1885-77: Ibbotson [1979], constructed for 1978 3) EWNY —— Eaually walahted equities Return on equally weighted porte folio of NVSEAisted stocks (CRSP) VWNY Value weighted equities Retura of a value weighted port Tollo of NYSE ised stock (CRSP) ca Consumption Grovah rae in eal per capita ‘consuraption (Hansen and Sin sleton [1882 Survey of Cur ont dsiness) 0G it prices Log telative of Peducer Price Tnden'Crude Petroleum series (Bureau of Labor Siatisuen) Derived Series Mir) ‘Moathiy grow, induseial logslPovte — 1 pradtction yr) Anal gros, indusisa pro- log HPQRITBCe 12), ‘duction UKE] Expected ination Fama and Gibbons (198) ice) Uoespestedialtion fy Fite 0 RHOC) Real interest (ex post) THe — Y= Ie) DEL) Change in expecte ination Bee + ila — BUCH — 1) URP) Risk premium Baste) — LGB) UTS() Term structure Gace) — Tee — 1 The monthly series of yearly growth rates, YP(¢}, was examined because the equity market is related to changes in industrial activity in the long run, Since stock market prices involve the valuation of cash flows over long periods in the future, monthly stock returns may not be highly related to contemporaneous monthly changes in rates of indus- trial production, although such changes might capture the information pertinent for pricing. This month's change in stack prices probably. reflects changes in. industrial production anticipated many months into ae {Journal of Business the future, Therefore, subsequent statistical work will ead this vari= able by 1 year, similar to the Variable used in Fama (1981). Because of the overlap in the series, YP(C) is highly autacorrelated. Approcedure was developed for forecasting expected YP(.) and a series of unanticipated changes in YP(1), and changes in the expectation itself were examined for their influence on pricing. The resulting series of: fered no discernible advantage over the raw production series, and, as a consequence, they have been dropped from the analysis. B Inflation Unanticipated inflation is defined as UIE) = 1) — EMO = 0, o where I() is the realized monthly first difference in the logarithm of the Consumer Price Index for period ¢. The series of expected inflation, E[I(a)|¢ ~ 1] for the period 1953-78, is obtained {com Fama and Gib: bans (1984). If RHO(+) denotes the ex post real rate of interest applica- ble in period 1 and TAC ~ 1) denotes the Treasury- bill rate knawn at the end of period r ~ 1 and applying to period f, then Fisher's equation asserts that TBE = = EIRHOC|e — 1] + ElKen|e — 11 @ Hence, TB(¢ ~ 1) ~ I{2) measures the ex post real return on Treasury bills in the period. From a time-series analysis of this variable, Fama and Gibbons (1984) constructed a time series for E[RHO(?}¢ — 1], Our ‘expected inflation Variable is defined by subtracting their time series for the expected real atc from the TB(t — 1) series. Another inflation variable that is unanticipated and that might have an influence separable from UL is DEM® = Ell@ + Nid — Elle — 0, o the change in expected inflation. We subscript this variable with ¢ since it is (in principle) unknown at the end of month — 1. While, strictly speaking, DEI(¢} need not have mean zero, under the additional as- sumption that expected inflation follows a martingale this variable may be treated as an innovation, and it may contain information not present in the UL variable, This would occur whenever inflation forecasts are influenced by economic factors other than past forecasting errors. ‘(Notice that the UL series and the DEI series will contain the informa- tion ina series of innovations in the riominal interest rate, TB.)° 4, Reals that include these series are available in 20 eater draft of the paper, which is avaiable fam the authors request 5. 88 an aside, the resulting unanticipated inflation varebe, CII), i perfectly negae tively correlated with the unantiigated change i the real rate, This follows fom the observation thatthe Fisher equation (6) bas for resized rates at wel a foc expecta Yians. The UIC? series alto tas sree coreation of 98 with the unanticipated nation series in Fama (1981. Economls Forces and the Stock Market 39 C. Risk Premia To capture the effect on returns of unanticipated changes in risk pre- mia, we will employ another Variable drawn from the money markets. ‘The variable, UPR, is defined as UPR(r) = “Baa and under" bond portfolio return (1) ~ LGB(®), (8) where LGB(¢) is the return on a portfolio of long-term government bonds obtained from Ibbotson and Singuefield (982) for the petiod 1953-78, From 1979 through 1983, LGB() was obtained from the Cen- ter for Research in Scourities Prices (CRSP) data file. Again, UPR is ‘not formally an innovation, but, as the differences in two return series, is sufficiently uncorrelated that we can treat it as unanticipated, and ‘we will use it as a member of the set of economic factors ‘The low-grade bond return series is for nonconvertible corporate bonds, and it was obtained from R. G. Ibbotson and Company for the period prior to 1977. detailed description of the sample is contained in fbbotson (1979). The low-grade series was extended through 1983 by choosing 10 bonds whose ratings on January 1966 were below Baa. BY 1978 these. bonds still were rated below Baa, but their maturity was shorter than that of the long-term government bond series, ‘These 10 bonds were then combined with three that were left over from the Thbotson series at the end of 1978 to cteate a low-grade bond portfolio of 13 bonds in all. The returns on this portfolio were then used 10 extend the UPR seties beyond 1977 and through 1983. Two further difficulties with the series are that the ratings have experienced consid- erable inflation since the mid-1950s and that the low-grade series con- tains bonds that are unrated. The UPR variable would have mean zero in a risk-neutral wortd, and it is natural (0 think of it as a direct measure of the dégree of risk aversion implicit in pricing (atleast insofar as the rating agencies main- tain constant standards for their classifications). We hoped that UPR would reflect much of the unanticipated movement in the degree of risk aversion and in the level of risk implicit in the market's pricing of stocks. D. The Term Structure To capture the influence of the shane of the term structure, we employ another interest rate variable, UTS) = LGB) ~ TBE ~ 1). o 6, Ie could be argued chat UPR capcures a leverage eect, with highly levered mss being stsociaed with tower eatings. Furthermoce, UPR is also sitar to a measure of ‘ely retire since a sibstaril portion ofthe valve of low-grade bonds comes fram the fame sort of call option (behind Secured det for ocdinay stock 0 ‘Journal of Business Again, under the appropriate form of risk neutrality, EIUTSC|e — 1] = 0, 1a} and this variable can be thought of as measuring the unanticipated return on long bonds, The assumption of risk neutrality is used only to isolate the pure term-siructure effects; the variable UPR is used to capture the effect of changes in risk aversion E. Market Indices ‘The major thrust of our effort is (0 examine the relation between non- equity economic variables and stock returns. However, because of the smoothing and averaging characteristics of most macroeconomic time series, in short holding periods, such as a single month, these series cannot be expected to capture all the information available to the mar- ket in the same period. Stock prices, om the other hand, respond very ‘quickly to public information, The effect of this is to guarantee that ‘market returns will be, at best, weakly related and very noisy relative to innovations in macroeconomic factors. This should bias our results in favor of finding @ stronger linkage between the time-series returns on market indices and other portfolios of stock returns than between these portfolio returns and innovations in the macro variables. To examine the relative pricing influence of the traditional market indices we used the following variables EWNY{(1) = return on the equally weighted NYSE index, VWNY{(z) = return on the value-weighted NYSE index. ‘These variables should reflect both the real information in the indus- trial production series and the nominal influence of the inflation vari- ables. F. Consumption In addition to the macro variables discussed above, we also examined a time series of percentage changes in real consumption, CG. The series is in real per capita terms and includes service flows. It was con- structed by dividing the CITIBASE series of seasonally adjusted real consumption (excluding durables) by the Bureau of Census’s monthly population estimates, The CG series extends from January 1959 to December 1983, and it is an extension of a series obtained from Lars Hansen for the period through 1979. A detailed description of its con- struction can be found in Hansen and Singleton (1983). G. Oil Prices Itis often argued that oil prices must be included in any list of the systematic factors that influence stock market returns and pricing. To {est this proposition and to examine another alternative to the macro variables discussed ahove, we formed the OG series of realized Beomamic Forces and the Stock Market a monthly first differences in the logarithm of the Producer Price Index! Crude Petroleum series (obtained from the Bureau of Labor Statistics, U.S. Department of Labor, DRI series no. 3884). The glossary in table 1 summarizes the Variables. H. Statistical Characteristics af the Macro Variables Table 2 displays the correlation matrix for the state variables. The correlation matrices of table 2 are computed for several different pe- TABLE Correlation Matrices fr Keanamic Variables Symbol EWNY VWNY MP DEL ULUPR UTS ‘A Jmuary 1953-Noverber 1983, vey 916 MP. 103 oa DEE igs 1119 a6 Ur 1 2067 st UPR 1528s urs wag 59 398 ssn ye vo oy 300s a9 BL January 1953-Decerber 1972 vwy 930 MP 7 at Det ino ur 10), “Maleivariate Approach As Yeus YP MP DEL OUT UPR UTS Constant Bee AM B98 er tata CS GTM) 1499) (208 BAT C1 ae) we 40 ist 13 sy 5384868 <2 AIM Cis) 28) 19H (40) LIS) Hag eS age cay Laan 14 a9 2 ae 145) 50H (938) (347) GGL C26 468) nse sar om Bio Ta 9'“ia S CM .600 C=) 4a) Ma aT B MP UPR UTS Constant 198% 13.989 rrr re 3.561) es 0836) 1956-67 18.158 S560 008s «1.897, 33 om aT, 968-7718 986 Ba “ue —1'g89 26s 28%) (2559 (2334) vore-e4 “9.388 67 Wa? «588 cay 49) 1.047) © EWNY MP DEI Ul UPR «UTS Constant Ise Smt 14009 R= ee 5076409 G21) G7 (= 856 (254) BAS HTT) (BAB S867 65S 14936 008 =I) Sta TB 1] 226) (00) (8) AD Co a9 west7 234 17393 ae son sis S990) S84 (28) 715) (3.03) (336 78) C20) C58) wase | Gem 7563) L132 S23 “—amy 9.68 (90) 283) (9) (63) 5134 D MP DEI UL_—«UPR OUTS Constant 1958-84 Ws S88 NTL G03 (1.600; (2.376) 8%) 2.955) 1958-67 Wise 00s” = 09 869.57 789) (064 060) (1.980) ws68-77 S349 hase 388 toss “10708 “g's (3BH 3409 G98) (229) Cte 19784 is" =339 “6086 —S.908 15 452 (499) 9) TR 6) 867, Nott VWNY < veturn on the Wale wea NYSE index: EWNY ~ return on he 0, will be less valuable than will those that can insure against adverse movements in consumption, that is, those for which be < 0, It follows fom risk aversion that the risk-premium measure, &, should be positive. ‘The alternative hypothesis that we will examine states that B= r= bik + by aa) where 6 is a vector of betas on the economic state variables used above, and q is the vector of associated risk premia. The mull hy- pothesis of the consumption beta models would be that & is positive and that g is zero. Of course, it can alway’ be argued that the other variables pick up changes in the relative pricing of different consump- tion goods or correct errors in the measurement of real consumption Alternatively, although ovr updating procedure is an attempt to deal with intertemporal changes in the beta coefficients, it could also be argued that the factors could be correlated with such changes (sce. Cornell [1981] for a discussion of this possibility) Table 6 reports the results of these tests using the CG series of real per capita consumption growth described in Section-IIf. Becanse of data collection timing, the CG series, like the monthly production series, MP, may actually measure consuniption changes with a lag. To deal with this problem, we led the CG series forward by I month. The results with the contemporaneous CG series are uniformly less favor able for its pricing influence and are not reported, TABLES Pricing with Consumpcion Yer. CGMP DEL ULUPR UTS Constant Weed 684964 16h Lt] 2a 109) 500) (1-74) (2.250) 584) LIM CRB) 1966-77 48S BIS 66 90s HLA —9.IB—1 90 494) 288) ws 3555 770) (474) 42) ( Sk mm 442) a 09) 659) G55) (2419) torre 9 “B390 66 95) 0496) Nove —ratdsce te aretha eonamic Forces and the Stock Market a TADLE7 Pricing with OW Price Changes Yers 0G MP ODEL UPR UTS Constame 1958-84 2930 27M ops 3m eae 8TH 4.0 (996) (1406) (1193) C2) 4290. 340) lose 4958 tego OTe ‘3am 268 1975) aa (556) 198-17 “ms 4036 1.170 14 35 (396) Ba 2) i9rs-s6 273822718 tas 14.702 203) 28, 1465) G20) [Nore C0 pomth cate inva per capt consumption; OG = arosth ate nol prices VWNY crvon the vueweighted NYSE fader, BWNY © reure he egal wephed NYSE inden, ‘= "non groin tte i indus precuein, DEC ~ charge expected maton; UI Imaniatd lato: UPR = umccjat® csgei the Fak peur Bea sa under cen — Ionecn goverment had ei) and UTS ~ mised nage ett ste ng term guveraent Good ein Treacy late) states ae in pacatheses 1ce the CG series begins in 1959, the tests were conducted only for the period beginning in 1964, 5 years later. In these tests the consump- tion betas and the factor betas are estimated simultaneously and then the risk premia are measured from the cross-sectional tests, Over the ‘entire period and in no subperiod are the consumption betas significant for pricing. Furthermore, their signs are negative, and a comparison with the results of part Bof table 4 shows that the coefficients and the significance of the state variables are unaltered by the presence of the CG betas. To summarize the results of this subsection, the rate of change in consumption does not seem to be significantly related to asset pricing. ‘The estimated risk premium is insignificant and has the wrong sign. ©. Oil and Asset Pricing Oil prices are often mentioned as being an important economic factor ‘even though there is no a priori reason to believe that innovations in oil prices should have the same degree of influence as, for example, inter- {st rate variables or industrial production. To examine the independent influence of oil prices on asset pricing, we used the methods described above to test the impact of the OG series of petroleum price changes. Table 7 reports on these tests. AS with the consumption tests, the 0G series was led by I month to enhance its influence. The oil betas were insignificant for pricing ia the overall period and in two of the subperiods. As a comparison with part B of table 4 shows, inclusion of ‘il growth did reduce the significance of industrial production, but it increased the significance of the risk-premium variable (UPR) and the term-structure variable (UTS). The risk associated with oil price changes was not priced in the stock market during the critical 1968-77 subperiod, when the OPEC cartel became important (or in the later subperiods) a Journal of Business V. Conclusion This paper has explored a set of economic state variables as systematic influences on stock market returns and has examined their influence on asset pricing. From the perspective of efficient-market theory and ra- tional expectations intertemporal asset-pricing theory (see Cox et al 1985), asset prices should depend on their exposures to the state vari- ables that describe the economy. (This conclusion is consistent with the asset-pricing theories of Merton [1973], Cox et al, [1985], or the APT [Ross 1976].) In Patt Il of this paper we used simple arguments to choose a set of economic state variables that, a priori, were candidates as sources of systematic asset risk. Several of these economic variables were found to be significant in explaining expected stack returns, most notably, industrial production, changes in the risk premium, twists in the yield curve, and, somewhat more weakly, measures of unant

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