The Quarterly Review of Economics and Finance 77 (2020) 62–74

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The Quarterly Review of Economics and Finance

journal homepage: www.elsevier.com/locate/qref

Macroeconomic variables and stock Market indices:

Asymmetric dynamics in the US and Canada
Erfan M. Bhuiyan a , Murshed Chowdhury b,∗
a
New Brunswick Institute for Research, Data and Training, University of New Brunswick, Fredericton, NB, E3B 5A3, Canada
b
Department of Economics, University of New Brunswick, Fredericton, NB, E3B 5A3, Canada

a r t i c l e i n f o a b s t r a c t

Article history: While the relationship between stock market returns and macroeconomic variables have been amply
Received 11 July 2019 examined, there is a gap in the literature when it comes to the relationship between different sector
Received in revised form 3 October 2019 indices and various macroeconomic variables. This study examines how certain macroeconomic vari-
Accepted 23 October 2019
ables influence different sectors of the stock market differently in the US and Canada. Using monthly
Available online 12 November 2019
data over the 2000–2018 period, a cointegration analysis is applied to model the relationship between
industrial production, money supply, long-term interest rate, and different sector indices. Sectors that
JEL classification:
have been examined in this study include energy, financials, real estate, industrial, healthcare, consumer
C32
E22
discretionary, and consumer staples. Results suggest that there is a stable long-term relationship between
E44 the macroeconomic variables used in the study and different sector indices for the US but not for Canada.
G12 However, US money supply and interest rate can explain the Canadian stock market. The results suggest
important insights for private investors, pension funds, and governments as long-term investors often
Keywords: base their decision to invest in equities on the stated macroeconomic variables.
Cointegration
© 2019 Board of Trustees of the University of Illinois. Published by Elsevier Inc. All rights reserved.
Macroeconomic variables
Stock market returns
Sector indices

1. Introduction sector-specific indices of the US and Canadian stock markets using

The relationship between macroeconomic variables and stock
returns has been of great interest to both academics and prac-
titioners. Over the past few decades, attention to the topic has
generated substantial literature that examined such possible asso-
ciations using a variety of frameworks. While the relationship
between stock market returns and macroeconomic variables has
been amply examined (Dhakal, Kandil, & Subhash, 1993; Humpe
& Macmillan, 2009; Nasseh & Strauss, 2000), there is a void in the
literature exploring such a relationship in terms of sector-specific
indices of the stock market. Analysis based on the composite index
masks the sensitivity of response of individual sectors and carry-
ing out a sector-wise analysis would provide sharper insights to
observe the direction and strength of the movement for each sec-
tor due to changes in macroeconomic variables. In this paper, we
explore the relationship between the macroeconomic variables and
∗ Corresponding author.
E-mail addresses: Erfan.Bhuiyan@unb.ca (E.M. Bhuiyan),
Murshed.Chowdhury@unb.ca (M. Chowdhury).
the time series technique over the 2000M1-2018M6 period.
Proponents of the Efficient Market Hypothesis (EMH) suggest
that all publicly available information is already incorporated in
stock prices and as such, economic indicators will be unable to have
an influence on stock returns (Fama, 1970). The conclusions drawn
by the EMH have been challenged by a variety of approaches that
provide evidence that key macroeconomic variables help to pre-
dict time series of stock returns. Efficiency or lack of efficiency
of the market have important implications for different stake-
holders. Assuming different level of inefficiency in the market,
pension funds and long-term investors, often decide to invest in
equities on the perception that corporate cash flows grow in line
with the economy with a slowly moving discount rate (Humpe &
Macmillan, 2009). On the other hand, if the market is efficient, then
governments can conduct macroeconomic policies without influ-
encing capital formation and stock trade process (Maysami, Howe,
& Hamzah, 2004).
Earlier studies use the Arbitrage Pricing Theory (APT) frame-
work, developed by Ross (1976), to capture the effects of economic
forces on stock returns. The APT modeled asset returns as a lin-
ear function of different risk factors including macroeconomic
variables and the sensitivity of each factor was captured by the

https://doi.org/10.1016/j.qref.2019.10.005
1062-9769/© 2019 Board of Trustees of the University of Illinois. Published by Elsevier Inc. All rights reserved.
 E.M. Bhuiyan, M. Chowdhury / The Quarterly Review of Economics and Finance 77 (2020) 62–74
coefficients using the multivariate regression framework. A host
of works using the APT framework includes Chen, Roll and Ross
(1986), Poon and Taylor (1991); Hamao (1988), Martinez and Rubio
(1989), Schwert (1990), Ferson and Harvey (1991). These papers
find a significant relationship between stock market returns and
money supply, interest rate, and real economic activity questioning
the validity of the EMH.
The advent of cointegration by Engle and Granger (1987)
allows for an alternative approach to study long-term equilib-
rium relations between variables without having to worry about
spurious correlations. Regressions in the APT framework with non-
stationary variables were susceptible to such correlations. Since its
development, a host of literature (e.g. Mukherjee & Naka, 1995;
Cheung & Ng, 1998; Nasseh & Strauss, 2000; Ratanapakorn &
Sharma, 2007; Humpe & Macmillan, 2009) examine and find sig-
nificance of macroeconomic variables in explaining stock market
returns further questioning the validity of the EMH. The growing
literature is mostly limited to the US and a handful of industrial-
ized countries but not Canada. Despite a strong trading relationship
between the US and Canada, the responsiveness of Canadian stock
indices due to the changes in macroeconomic variables could be
different than the US due to the independence of monetary policy
across the US and Canada. To the best of our knowledge, none of the
existing studies have examined the association between the US and
Canadian stock indices with their respective macroeconomic vari-
ables. They also ignore how macroeconomic variables in the US can
influence Canadian stock indices and vice versa. Additionally, the
majority of the studies, if not all, use composite stock market indices
which ignores the fact that the responsiveness of stock indices due
to the changes in macroeconomic variables could vary across sec-
tors. For example, stocks in financials could be more responsive due
to changes in macroeconomic variables as opposed to the stocks
in health care and vice-versa. In this paper, we focus on answer-
ing three questions using unit root, cointegration, and vector error
correction methods: (1) Is there any long-run relationship between
the macroeconomic variables and respective composite as well as
sector-specific stock market indices in the US and Canada? (2) What
is the direction of relationship between the macroeconomic vari-
ables and stock indices? (3) Is there any relationship between the
US macroeconomic variables and Canadian stock indices and vice
versa?
We contribute to the existing literature in four ways. First, while
earlier studies limited to the US and some other industrialized
countries but not Canada, we extend it to comparable Canadian
indices to investigate whether the domestic macroeconomic vari-
ables can influence stock indices differently in the US and Canada.
Second, although there have been many studies examining the
association between composite stock market indices with macroe-
conomic variables, there is a dearth in those extending the analysis
to include sector specific stock market indices. Third, while most
of the previous studies limited their discussion to how domestic
macroeconomic variables can influence its stock market indices,
we will investigate how the US and Canadian macroeconomic vari-
ables can influence each other. Fourth, we cover the longest time
since the introduction of sector specific stock market indices.
This study uses the key composite indices, i.e. S&P500 for the
US and TSX for Canada. Our sectoral indices include, energy (Enr),
financials (Fin), consumer discretionary (CD), consumer staples
(CS), real estate (RE), health care (HC), industrials (Ind), materi-
als (Mat), utilities (Uti), and technology (Tec). The macroeconomic
variables that have been used in this study are money supply,
long-term interest rate, and real economic activity. Applying the
cointegration and vector error correction approach, our key results
suggest that there are substantial variations between how macroe-
conomic variables are associated with stock market indices in the
US and Canada. We find that macroeconomic variables in the US
63
influence its composite as well as sector-specific indices. The sen-
sitivity of sectoral indices varies, however. For Canada, there is no
association between stock indices, either composite or sectoral,
with certain macroeconomic variables considered in this study.
Canada is a small open economy and is heavily dependent on
international trade and commodity prices in contrast to the US.
Moreover, the monetary policy is straightforward, and the only pol-
icy instrument the Bank of Canada uses is the target it sets for the
overnight interest rate to achieve its inflation target whereas the
monetary policy is more involved and intricate for the US. Further-
more, the US macroeconomic variables have a strong influence in
the Canadian stock indices while the opposite is not true.
The remainder of this study is organized as follows. In Section
2, we review the existing literature that contextualizes our paper,
first from the theoretical perspective and then from the empir-
ical perspective. In Section 3, we describe the data, model, and
methodology used in this paper. Section 4 shares the results and
elaborates the relevant discussion. Further, it provides important
insights about the differences in outcome. Section 5 concludes the
paper.
2. Review: theory and empirics
The pioneering work by Fama (1970) suggests that based on
the efficient market hypothesis (EMH) stock prices reflect all pub-
licly available information and, as such, lags of financial variables
will not be able to predict future stock prices. However, Abdullah
and Hayworth (1993) argue that most previous studies that sup-
port the EMH are based on daily and weekly models that do not
incorporate variables that the EMH theory predicts. Proponents of
the EMH claim that only unanticipated changes in macroeconomic
variables are able to influence the stock market (e.g. Sorensen,
1982; Davidson & Froyen, 1982; Pearce & Roley, 1983). Samuelson
(1998) argues that while the stock market may be “micro efficient”,
it is “macro inefficient” which means that the EMH may be appli-
cable for individual stocks but not the aggregate stock market. This
concept of the stock market being “micro efficient” but “macro
inefficient” became known as Samuelson’s dictum which is backed
up by some empirical evidence such as Shiller (1981), Campbell
and Shiller (1988), Vuolteenaho (2002), Cohen, Christopher, and
Vuolteenaho, (2003)) using vector autoregressive models.
As mentioned above, the existing literature largely uses two key
approaches to examine the link between macroeconomic variables
and stock market indices. While the earlier studies (Chen et al.,
1986; Fama & French, 1989; Fama, 1981; Hamao, 1988; Poon &
Taylor, 1991; Schwert, 1990; Ferson & Harvey, 1991) use the Arbi-
trage Pricing Theory (APT) framework developed by Ross (1976),
more recent studies use cointegration technique. The APT assumes
that an asset’s return is a linear function of economic and financial
variables and is basically a linear multifactor model that aims to
measure the risk attached to the factors that influence the price of
the asset. When asset’s returns are regressed on different factors
in a multivariate regression framework, the coefficients capture
the risk/sensitivity of each factor. Chen et al. (1986) using monthly
data from the US for the period of 1958–1984 and employing the
APT framework observe that while the relationship between stock
returns, industrial production, changes in risk premium and the
changes in the term structure are positive, both expected and unex-
pected inflation are negatively associated with stock returns due to
their impact on future dividends and discount rate.
Poon and Taylor (1991) investigate whether the results found by
Chen et al. (1986) above for the US can be extended to the UK market
using monthly data for the period of 1965–1984. The authors find
that comparable variables for the UK do not affect UK stock returns.
The authors suggest that there could be other macroeconomic fac-
64 E.M. Bhuiyan, M. Chowdhury / The Quarterly Review of Economics and Finance 77 (2020) 62–74
tors at work or that the methodology is inadequate to capture such
pricing relationships. The authors question whether the price of
assets changes in a linear manner and consequently if the APT
is an appropriate framework and also suggest adopting Granger-
causality tests to investigate such relationships. The authors further
point out that if size of a firm is an important factor in being influ-
enced by macroeconomic variables in the US then it might not be
possible to replicate the test for other countries as many uncon-
trollable variables such as company legislation, tax laws, other
economic variables vary from country to country. Hamao (1988)
replicates Chen et al. (1986) study for Japanese markets as a test
of robustness using monthly data for the period of 1975–1984.
The factors investigated in this study include industrial produc-
tion, interest rates, inflation, investor confidence, and exchange
rate. Results show that other than industrial production, all other
variables have an impact on equity returns in Japan. The sample
period for Hamao (1988) is much shorter than the sample period for
Chen et al., (1986) and Poon and Taylor (1991). Martinez and Rubio
(1989) replicate the above studies using monthly observations for
Spain and find no significant relationship between macroeconomic
variables and stock returns.
The development of cointegration analysis by Engle and Granger
(1987) allows an alternative approach to study the long-term equi-
librium relations between the stock market and different economic
variables. Prior to the development of cointegration analysis, lin-
ear regressions were used on non-stationary time series data and
Granger and Newbold (1974) shows that such approach could lead
to spurious correlations. If a set of time series variables are inte-
grated of the same order and their linear combination produces
a stationary series, then the set of those variables are said to be
cointegrated. Cointegration points to the existence of a long-term
equilibrium relationship and through error correction modeling,
the co-movement among the variables and the adjustment process
toward long-term equilibrium can be examined. Employing the
cointegration approach, a host of literature challenges the conclu-
sions drawn by the EMH and provide evidence that macroeconomic
variables help to predict the time series of stock returns (Cheung
& Ng, 1998; Humpe & Macmillan, 2009; Maysami & Koh, 2000;
Mukherjee & Naka, 1995; Nasseh & Strauss, 2000; Ratanapakorn &
Sharma, 2007).
Employing the cointegration and the Vector Error Correction
Model (VECM) for monthly data from US, Ratanapakorn and Sharma
(2007) find that the S&P 500 has a positive relationship with money
supply, industrial production, inflation, exchange rate, and the
short-term interest rate but a negative relationship with the long-
term interest rate. Further, the authors claim the stock market in
the US does not seem to be efficient and can be forecasted by the
information provided by these variables. Humpe and Macmillan
(2009) conduct a similar exercise using the S&P 500 and the Nikkei
225 for the US and Japan respectively. The authors find that for the
US, consumer price index and the long-term interest rate have an
inverse relationship, but industrial production and money supply
are positively associated with stock price although effect of money
supply is not statistically significant. For Japan, stock prices are neg-
atively related to money supply and positively related to industrial
production and the authors claim that the consumer price index
indirectly has a negative impact on stock prices through its effect
on industrial production first. The authors attribute the contrast-
ing result for money supply to the liquidity trap that the Japanese
economy faced during the 1990 s where increasing money supply
and falling interest rates were unable to pull the Japanese economy
out of its slump. Mukherjee and Naka (1995) also find the positive
relationship between the Tokyo Stock Exchange (TSE) with indus-
trial production, money supply, short-term interest rate, exchange
rate and negative with long-term bond rate, and inflation. The
authors suggest that long-term bond rate is a better proxy than
short-term call money rate for the discount rate in the valuation
model of stock returns, since long-term bond rate has a negative
relationship with the TSE while call money rate has a positive rela-
tionship. Lee and Gan (2006) examine the relationship between
several macroeconomic variables including money supply, long-
and short-term interest rates, exchange rate, and inflation rate with
the officially published index of the New Zealand Stock Exchange
(NZSE40) using cointegration framework on monthly observations
from January 1990 to January 2003. The results show that these
macroeconomic variables have a long-term equilibrium relation-
ship with the NZSE40. However, based on the Granger causality
tests the authors suggest that money supply and the long-term
interest rate are not important in determining stock returns in the
short-run.
Cheung and Ng (1998) study on Germany, Italy, Japan, and the US
suggest that the effect of money supply and gross national product
on stock market indices are ambiguous given the different direc-
tion of influence these variables have over different countries. For
instance, money supply has a positive association with the compos-
ite indices for Germany and Italy while it has an inverse relationship
for Japan and the US. The authors conclude that the inconclusive
result is perhaps due to perceived differences in the monetary pol-
icy implemented across countries. The authors also compare the
VECM with VAR and finds that inclusion of error correction term
in the VECM is an improvement over VAR based on the value of
adjusted R2 . In a similar study, Nasseh and Strauss (2000) inves-
tigate if the stock indices and macroeconomic variables exhibit a
cointegrating relationship for Germany, France, Italy, Netherlands,
Switzerland, and the UK. Results show that there is a long-term
equilibrium relationship between the stock indices of each country
with their domestic industrial production index, long- and short-
term interest rates, and inflation. Generally, industrial production
has a positive association while the long-term interest rate has a
negative association with the stock index. The direction of influ-
ence is consistent across all countries. Nesseh and Strauss also test
whether German macroeconomic variables can influence the stock
indices for France, Italy, Netherlands, Switzerland, and the UK given
the strong economic linkage of these economies with Germany.
Results show that the German short-term interest rate, stock prices,
and industrial production significantly affect stock prices in the
other five economies while the reverse is not true.
The literature examining the relationship between macroe-
conomic variables and sector-specific stock indices is scanty.
Maysami, Howe, and Hamzah, (2004) study whether Singapore’s
financials and real estate along with a composite index form a
cointegrating relationship with inflation, money supply, short-
and long-term interest rates, and exchange rate using monthly
observations from January 1989 to December 2001. For the finan-
cials sector, money supply, inflation, and short-term interest rate
have a positive relationship, while industrial production, long-term
interest rate, and exchange rate have a negative relationship with
the sector index. For the real estate sector, industrial production,
money supply, inflation, and short-term interest rate have a pos-
itive relationship and long-term interest rate and exchange rate
have a negative relationship with the real estate index. For the com-
posite index, money supply, industrial production, inflation, and
short-term interest rate have a positive relationship while long-
term interest rate and exchange rate have a negative relationship
with the index.
A survey of various studies has shown that there is a gap in
the literature when it comes to exploring the relationship between
macroeconomic variables and sector specific stock indices. To the
best of our knowledge, none of the existing studies have explored
the sensitivity of sectoral indices with macroeconomic indicators.
Despite having apparent similarities between the US and Canada in
macroeconomic structure, no research has investigated a compara-
 E.M. Bhuiyan, M. Chowdhury / The Quarterly Review of Economics and Finance 77 (2020) 62–74
tive picture of how domestic and international factors can influence
stock market indices for both countries. Moreover, to the best of our
knowledge, we did not encounter any recent studies on this topic
incorporating recent data since the great recession in the US. This
could be important because the financial crisis of 2007–2008 could
have altered the economy fundamentally in such a way that the
long-term relationship between the S&P 500 and different macroe-
conomic variables after the crisis may behave differently compared
to the period before the crisis. Hence, we address those gaps in the
following sections.
3. Data and methods
3.1. The model
A pertinent issue is the mechanism behind how variables were
chosen to examine their relationship with the stock market. Most
authors base their choice of variables through “simple and intu-
itive financial theory” as noted by Chen et al. (1986). The financial
theory involves how the stock prices are determined in terms
of expected cash flow and discount rate. If there exists a pos-
sibility that a change in macroeconomic variable results in a
change in expected cash flow or discount rate then there is a
corresponding change in stock prices and as such, the relation-
ship between that variable and stock prices may be examined.
Among others, Mukherjee and Naka (1995), Cheung and Ng (1998),
Maysami and Koh (2000), Nasseh and Strauss (2000), Ratanapakorn
and Sharma (2007), Humpe and Macmillan (2009) use such an
approach to decide which variables to incorporate in their stud-
ies.
Theory suggests that an increased money supply may affect the
discount rate positively or negatively and thereby the consequent
impact on stock prices is inconclusive (Mukherjee & Naka, 1995). On
one hand, increased money supply may lower the interest rate due
to increased liquidity and consequently resulting in an increase in
stock prices due to lower discount rate (Ratanapakorn & Sharma,
2007). On the other hand, increased money supply may result in
inflationary expectations and the interest rate may increase as a
consequence, which increases the discount rate and consequently
results in lower stock prices (Dhakal et al., 1993). There are other
theoretical channels through which money supply may influence
stock prices as well. For instance, portfolio-balance model suggests
that an increased money supply may cause a portfolio shift from
non-interest-bearing money to financial assets such as equities
(Friedman & Schwartz, 1963; Friedman, 1961). Also, an increase
in money supply may act as a stimulus for economic growth which
may increase expected cashflows (Mukherjee & Naka, 1995).
Several studies attempt to theoretically justify that industrial
production, as a proxy for real economic activity, has a pos-
itive association with stock prices (Dhakal et al., 1993; Fama,
1990; Schwert, 1990). In theory, however, the lead-lag relationship
between the industrial production and stock prices is unclear. First,
increased output may reflect accumulation of real assets which
increases the productive capacity of an economy and consequently
increases the ability of firms to generate higher expected cash flows
in the future, and this may enhance stock price (Maysami et al.,
2004). Alternatively, higher stock prices indicate increased wealth
which may increase the demand for consumption and investment
goods (Fama, 1990).
The theory on the impact of interest rate on stock prices is
straightforward and suggests an inverse relationship. A higher
interest rate will increase the discount rate via its effect on the
nominal risk-free rate which will result in lower stock prices (Chen
et al., 1986). Additionally, an increased interest rate may raise the
financing cost which will reduce the profitability of the firm and
65
consequently the unit price of its shares (Ratanapakorn & Sharma,
2007).
Our study proceeds in the following steps. First, we test the sta-
tionarity of all the series using the Augmented Dickey Fuller (ADF)
method. Second, we determine the order of integration of the series
if it contains a unit root. Having all the series integrated of order
1 indicates the appropriateness of using the cointegration tests.
Third, the study proceeds with an unrestricted Vector Auto Regres-
sion (VAR) model to determine the lag length to be employed in the
cointegration tests. Fourth, the Johansen cointegration tests iden-
tify whether the variables are cointegrated or not. Finally, if the
variables are cointegrated, we estimate a stable long-run relation-
ship. Subsequently, we run a Vector Error Correction Model (VECM)
to determine the speed of adjustment for any variables deviating
from its long-run path. If variables are not cointegrated, VAR models
only capture the short-term relationships. Our choice of empirical
method is based on the characteristics of the data and existing lit-
erature (Greene, 2012; Mukherjee & Naka, 1995; Nasseh & Strauss,
2000). As we are interested in examining the long-run relationship
between stock market indices and macroeconomic variables, there-
fore, we use the cointegration technique proposed by Johansen
(1995). The cointegration method has several characteristics that
make it a preferred technique over several other techniques includ-
ing the linear regression. It takes care of the issues related to the
spurious relationships due to the non-stationary nature of data.
If the variables are integrated of I(1), using any technique which
does not accommodate for the non-stationarity of data would be
misleading. Differencing of the non-stationary variables does not
always resolve the problems of spurious relationships (Greene,
2012). The cointegration also resolves the issues related to reverse
causality between variables. The flexible functional form of the
Johansen (1995) cointegration treats all variables as endogenous
and avoids the arbitrary choice of the dependent variable in the
cointegrating equation. Hence, the use of cointegration is more
appropriate in our case.
3.2. Unit root tests
Economic and financial variables usually exhibit trending
behavior i.e. the series are non-stationary in their mean. Existence
of a unit root in a series means that the series is not station-
ary. Consequently, using non-stationary time series in a regression
framework may lead to spurious regression and futile economic and
statistical inference unless cointegration tests are performed where
all the series need to be integrated of the same order. For the pur-
pose of this study all the time series variables must be integrated
of order 1. The Augmented Dickey Fuller (ADF) test has been used
in this paper to test for a unit root. Given the nature of the variables
in this paper, the null hypothesis under the ADF test contains a unit
root with a constant and a time trend. The following regression,
which corresponds to a random walk with drift and time trend, is
estimated to implement the ADF test:

P
Yt = ∝ + ıt + Yt−1 + i Y t−i + εt (1)
i =1
Where  is the difference operator, Y corresponds to the variable,
ıt represents the time trend, P is the number of lags and ␧ repre-
sents the error term. The number of lags is chosen by the Akaike
Information Criteria (AIC). The t-statistic of ␪ is compared to the
ADF critical values to determine if the series contains unit root.
3.3. VAR
Vector Auto Regressive (VAR) models attempt to capture linear
interdependencies among multiple time series. These models are
66 E.M. Bhuiyan, M. Chowdhury / The Quarterly Review of Economics and Finance 77 (2020) 62–74

extensions of univariate Auto Regressive (AR) models by allowing ables. This test is based on a general VAR model with n variables
for more than one dynamic variable. While in a standard regression (Johansen, 1995):
framework, dependent and independent variables interact simul-
taneously, in VAR models, evolution of each variable is based on the 
K

lagged values of itself, and lagged values of other variables in the Yt = v + i Yt−i + εt (6)
model. The VAR model in this study is as follows: i=1


p

p The following equation is derived after subtracting Yt-1 from
Indext = ∝0 + ˇ1i Indext−i + ˇ2i IP t−i both sides:
i=1 i =1
 
K−1

p
p Yt = v + Y t−1 + џi Yt−i + εt (7)
+ ˇ3i M1t−i + ˇ4i LIRt−i + εt (2) i=1
i =1 i=1

 
K 
K

Here, = i − I and џi = − j

p

p
I=1 j=i+1
IP t = 0 + 1i Indext−i + 2i IP t−i In the above equations, Y is the n by 1 vector of endogenous
i=1 i =1 variables, v is a vector of parameters, ␧ is the vector of residuals. ␪
is the n by n matrix of parameters for endogenous variables, and I

p

p

+ 3i M1t−i + 4i LIRt−i + t (3) is the identity matrix of dimension n. The matrix has rank 0 ≤
r < n, where
 r is the number of linearly independent cointegrating
i =1 i=1
vectors. can be written as the product of ∝ and ␤’ matrices where
∝ represents the parameters for the speed of long-run adjustment

p

p and ␤ contains r cointegrating vectors.
M1t = 0 + 1i Indext−i + 2i IP t−i The trace test and maximum eigenvalue test determines the
i=1 i =1
number of cointegrating vectors. The null hypothesis for the trace
test is that there are at most r cointegrating relations against the

p

p
alternative j cointegrating equations where r = 0, 1,2, . . ., j – 1. The
+ 3i M1t−i + 4i LIRt−i + D t (4) null hypothesis for maximum eigenvalue test is that there are r
i =1 i=1 cointegrating relations against the alternative of r + 1 cointegrating
relations.


p

p

LIRt = 0 + 1i Indext−i + 2i IP t−i 3.5. Vector error correction model

i=1 i =1
A Vector Error Correction Model (VECM) is a restricted Vector

p

p
Autoregressive (VAR) model designed to use with series that are
◦
+ 3i M1t−i + 4i LIRt−i + et (5)
cointegrated and are non-stationary in level form. The VECM is just
i =1 i=1 a special case of VAR for variables that are stationary in their differ-
ences. In VECM, while the model specification allows for short-run
Where, Indext represents changes in composite or sector indices,
adjustments, the long-run behavior of the endogenous variables
Mt represents changes in M1 money supply, LIRt represents
is restricted so that they converge to their cointegrating relation-
changes in the long-term interest rate, IPt represents changes
ships. The cointegration term in the VECM equation is called the
in real economic activity. ˇ, , , and are vector of parameters
error correction term because the deviation from long-run equi-
for the variables. The optimal length in this study is determined
librium is corrected gradually through a series of partial short-run
by using the Akaike’s Information Criteria (AIC) because according
adjustments. In the context of this study, even if stock index, money
to Ivanov and Kilian (2001), AIC tends to be more accurate with
supply, and industrial production are non-stationary series, should
monthly data in the context of VAR models compared to Hannan-
they be cointegrated, then error correction model can be applied.
Quinn Criterion (HQC) and Schwarz Information Criterion (SIC).
The multivariate VECM in this study is specified as follows:

3.4. Johansen cointegration 

p

p

Indext = ∝0 + ˇ1i Indext−i + ˇ2i IP t−i

When a set of time series variables are each integrated of the i=1 i =1
same order, then if a linear combination of these variables produce a

p

p
series which is integrated of order zero, then the set of variables are + ˇ3i M1t−i + ˇ4i LIRt−i + 1 zt−1 + εt (7)
said to cointegrated. Cointegration is generally utilized to examine
i =1 i=1
whether there exists a stable long-run relationship among two or
more variables. In the context of this study if stock indices, interest
rate, money supply, and real economic activity are integrated of 
p

p
order 1 and if the combination of these variables results in a series IP t = 0 + 1i Indext−i + 2i IP t−i
integrated of order zero then it can be suggested that there exists a i=1 i =1
long-run relationship among these variables. Should the variables
be cointegrated, vector error correction model can be applied to 
p

p

test the dynamics among the variables. + 3i M1t−i + 4i LIRt−i + 2 zt−1 + t (8)
The Johansen cointegration test is applied in this study to i =1 i=1
determine the existence of a long-run relationship among the vari-
 E.M. Bhuiyan, M. Chowdhury / The Quarterly Review of Economics and Finance 77 (2020) 62–74 67


p

p Table 1
M1t = ∝0 + 1i Indext−i + 2i IP t−i ADF Unit Root Test for US Variables for 2000–2018.

i=1 i =1 Level First Difference

p
p Indices
S&P 500 −2.376 −5.663 ***
+ 3i M1t−i + 4i LIRt−i + 3 zt−1 + ët (9)
Enr −1.701 −10.094 ***
i =1 i=1 Fin −1.837 −3.834 **
CD −1.944 −6.855 ***
CS −2.577 −10.492 ***

p

p
RE −2.159 −4.813 ***
LIRt = ∝0 + 1i Indext−i + 2i IP t−i HC −1.323 −10.395 ***
i=1 i =1 Ind −2.803 −5.740 ***
Uti −2.133 −7.722***

p

p
Mat −3.274 −10.546 ***
+ 3i M1t−i + 4i LIRt−i + 4 zt−1 + t (10) Tec −3.625** NA
Macroeconomic Variables
i =1 i=1
IP −3.071 −4.242 ***
Where: Indext represents changes in composite or sector indices M1 −1.901 −5.050***
from one time period to the next; IPt represents changes in indus- LIR −3.064 −7.729 ***

trial production from one time period to the next; M1t represents
changes in money supply from one time period to the next; LIRt
represents changes in the long-term interest rate from one time
period to the next. All the variables are in natural logarithmic form.
‘p’ denotes the number of lagged differences. ‘z’ is the error correc-
tion term. ␧, ␮, ë, and t represent error terms. The coefficient ␭, of
the error correction term measures the speed of adjustment when
there is a deviation from the equilibrium. The coefficient vectors ␤,
, ␪, ␩ capture the short-run dynamics between the variables.
4. Data, results, and discussion
4.1. Data
This study uses monthly observations for all the stock indices
and macroeconomic variables over the period ranging from January
2000 to June 2018 for the United States and from January 2000 to
April 2018 for Canada. The sample for the US contains 222 observa-
tions, the sample for Canada includes 220 observations. Data for
the US sector indices are available from January 2000 and data
for most Canadian sectors are available from 1997. For comparison
purposes with the US, this study uses Canadian data from January
2000. The data for all the macroeconomic variables, industrial pro-
duction index, long-term interest rate, and narrow money supply
have been collected from the Federal Reserve Bank of St. Louis for
both countries. Prior studies use M1 money supply and the indus-
trial production index to capture the effects of money supply and
real economic activity respectively, and to be consistent, this paper
also uses M1 money supply and the industrial production index.
Following Humpe and Macmillan (2009), seasonally adjusted data
for M1 and Industrial Production are used in this study as these
variables exhibit strong seasonality. To capture the effect of the
long-term interest rate, most studies use 10-year or 5-year govern-
ment bond rate. This paper uses benchmark 10-year government
bond rate, since data for this series is available for both Canada and
the US at the Federal Reserve Bank of St. Louis. While most studies
use additional variables such as the short-term interest rate, infla-
tion, and exchange rate, they generally test the relationship against
a single benchmark index of a country. Since this paper investigates
ten different indices for the US and ten different indices for Canada,
attention was given to a parsimonious model with sufficient num-
ber of macroeconomic variables.
All the stock market composite and sector indices data for both
the countries have been obtained from Bloomberg and are based
on the closing price of the indices on the last business day of each
month. All the level series of indices and macroeconomic variables
are expressed in natural logarithmic form. Variable description and
summary statistics are presented in Appendix A. Companies listed
in all the sector indices for the US are selected from the stocks listed
Notes: The numerical values represent ADF test statistic. ***␳≤0.001, **␳≤0.005,
*␳≤.01. All the level series are in natural logarithmic form.
in the S&P 500. For the US sector indices, the weight of any single
index constituent is capped at 20 %. For Canada, constituents of all
the sector indices are selected from a stock pool of the benchmark
S&P/TSX composite index. For Canadian indices, the weight of any
single index constituent is capped at 25 %. All the sector indices
are based upon the Global Industry Classification Standards (GICS).
The GICS is an industry classification system developed by MSCI
(formerly Morgan Stanley Capital International) and Standard and
Poor’s (S&P) for use by the global financial community.
There are various forms of indices such as uncapped, equal
weight, 35 % capped, and 20 % capped index for almost all the sec-
tors for the US. However, forms of sector indices data are limited
for Canada. For comparison purposes across all sectors with the US,
only 25 % capped index is available. For the US, 20 % capped indices
have been used. The rationale for using capped sector indices is
that, the number of stocks listed and consequently the market cap-
italization of sector indices is much lower compared to the original
benchmark index from which sector indices were created. Move-
ment in any stock, which forms much of a sector in terms of market
capitalization, could be due to company specific reasons and not
due to changes in macroeconomic variables. As a result, movement
in uncapped sector indices is subject to a lot of noise due to com-
pany specific factors, specifically those companies which have a
large weight in the sector. Such a problem does not exist for the
benchmark indices for the US or Canada due to the sheer number of
stocks listed in each of them. Market capitalization of an individual
stock listed in any of the benchmark indices is very low compared
to the entire index and as a result, movements in the price of a
stock due to company specific factors will hardly cause a dent in
the direction of the entire index.
4.2. Unit root tests
This study uses the Augmented Dickey Fuller (ADF) test to detect
the presence of unit root in the variables. The ADF tests are under
the null of a unit root with a constant and a time trend, which
was selected based on the trending behavior of all the series.
Tables 1 and 2 display the results of the ADF test for the different
stock indices and macroeconomic variables for the US and Canada
respectively. For the purpose of robustness check, results of the
Phillips-Perron test to detect the presence of unit root are presented
in Appendix B. Table 1 shows that for the US, all macroeconomic
series, S&P500 and all sector indices other than the technology
sector index contain unit root and are therefore non-stationary
processes, but the first difference of most of the series turn out
to be stationary. This suggests that all the variables other than the
68 E.M. Bhuiyan, M. Chowdhury / The Quarterly Review of Economics and Finance 77 (2020) 62–74

Table 2 Table 3
ADF Unit Root Test for Canadian Variables for 2000–2018. Cointegration Test for US Indices and Macroeconomic Variables for 2000–2018.

Level First Difference Indices Number of Trace statistic Max statistic

cointegrating
Indices
relationship (r)
TSX −2.804 −7.362 ***
Enr −1.886 −9.278 *** S&P 500 r=0 66.4367 44.2645
Fin −2.929 0.0046 *** r=1 22.1723** 15.8943**
CD −1.406 −7.809 *** r=2 6.2780 6.0377
CS −1.554 −7.667 *** Enr r=0 56.6225 33.8518
RE −2.851 −5.889 *** r=1 22.7708** 14.9256**
HC −1.475 −9.123 *** r=2 7.8451 6.2905
Ind −2.272 −8.092 *** Fin r=0 61.7050 36.2398
Uti −3.027 −6.647 *** r=1 25.4651** 15.7700**
Mat −1.436 −10.625 *** r=2 9.6951 9.0735
Tec −3.363* NA CD r=0 60.0300 42.2188
Macroeconomic Variables r=1 17.8112** 12.1290**
IP −1.692 −5.498 *** r=2 5.6821 5.3998
M1 −1.668 −9.063 *** CS r=0 59.8770 34.5743
LIR −2.178 −7.442 *** r=1 25.3026** 17.6118**
r=2 7.6908 7.6381
Notes: The numerical values represent ADF test statistic. ***␳≤0.001, **␳≤0.005,
RE r=0 64.1837 39.5034
*␳≤.01. All the level series are in natural logarithmic form.
r=1 24.6803** 15.4586**
r=2 9.2216 9.1374
HC r=0 47.21 27.07
technology sector index are integrated of order 1 in level form but
r=1 29.68 20.97
integrated of order 0 in first difference form. Since, the index for r=2 15.41 14.07
the technology sector is integrated of order 0 in level form, the Ind r=0 56.9095 27.5443
cointegration test cannot be performed for this sector. r=1 29.3652** 20.7590**
Table 2 shows that similar to the case in the US, in Canada, all r=2 8.6062 8.5580
Mat r=0 60.3503 32.6048
macroeconomic series, S&P/TSX and all sector indices other than
r=1 27.7454** 17.5273**
the technology sector index contain unit root and are therefore non- r=2 10.2181 10.1096
stationary processes, but the first difference of most of the series Uti r=0 70.9180 40.7032
turn out to be stationary. This suggests that all the variables other r=1 30.2148 23.2792
r=2 6.9357** 6.8755**
than the technology sector index are integrated of order 1 in level
form but integrated of order 0 in first difference form. Since the Note: ***␳≤0.001, **␳≤0.005, *␳≤.01.
index for the technology sector is integrated of order 0 in level form,
cointegration test cannot be performed for this sector for Canada
as well. Table 4
Cointegration Test for Canadian Indices and Macroeconomic Variables for
4.3. Cointegration tests 2000–2018.

Indices Number of Trace statistic Max statistic

Given that all the series, except for those representing technol- cointegrating
ogy sectors, are integrated of order 1 in level but integrated of order relationship (r)

zero in first differences for both the US and Canada, the Johansen S&P 500 r=0 37.0308** 18.3683**
cointegration test can be employed to see whether there exists r=1 18.6626 10.6666
r=2 7.9959 5.2682
a long-run relationship between the stock indices and industrial
Enr r=0 31.6042** 13.7036**
production, long-term interest rate and money supply. The trace r=1 17.9006 9.1548
statistic and the maximum eigenvalue statistic are compared with r=2 8.7458 5.9831
the critical value at 5 % level of significance. Tables 3 and 4 display Fin r=0 29.0896** 12.7180**
results using the Johansen cointegration test for the US and Canada, r=1 16.3716 9.1436
r=2 7.2280 5.2000
respectively. CD r=0 37.2123** 20.1998**
Choosing the number of lags is subjective and is dependent on r=1 17.0125 11.1437
a multitude of factors such as context of study, empirical evidence, r=2 5.8688 3.1538
and theory. Too few lags could result in residual autocorrelation CS r=0 36.8213** 23.8302**
r=1 12.9911 7.0412
and too many lags would lead to losing observations and error
r=2 5.9499 5.3737
in forecasts (Stock & Watson, 2001). This paper has tested for lag RE r=0 31.8286** 14.9835**
lengths between 1 and 12 and the Akaike Information Criteria (AIC) r=1 16.8450 9.0688
was chosen to determine optimal lag length. The AIC tends to be r=2 7.7762 5.5110
more accurate with monthly data in the context of Vector Auto HC r=0 40.1864** 25.7687**
r=1 14.4176 8.6298
Regression (VAR) models (Ivanov & Kilian, 2001). r=2 5.7878 3.3508
The trace and maximum eigenvalue statistics for the S&P 500 Ind r=0 37.0716** 16.2832*
and all the sector indices for the United States reject the null of r=1 20.7884 13.9328
0 rank, that is “Ho: no cointegrating vector”. For all the indices, r=2 6.8556 4.6315
Mat r=0 34.4853** 17.3312**
both the trace test and maximum eigenvalue test fail to reject
r=1 17.1541 9.2622
the null hypothesis that a rank of 1 exists. The results imply that r=2 7.8919 4.9849
there exists a singular cointegrating vector between the indices and Uti r=0 36.1843** 14.4494**
the macroeconomic variables. This means that there is evidence of r=1 21.7349 12.3348
long-term relationship among the indices and industrial produc- r=2 9.4001 5.9017

tion, money supply, and the long-term interest rates for the US. For Note: *** ***␳≤0.001, **␳≤0.005, *␳≤.01.
robustness check, different lag lengths suggested by other informa-
 E.M. Bhuiyan, M. Chowdhury / The Quarterly Review of Economics and Finance 77 (2020) 62–74 69

Table 5 relationship is positive and significant with energy and materials

Long -Term Equations for the US for 2000–2018.
sectors. The findings are in line with the exiting studies for com-
Indices IP M1 LIR Constant posite index. Researchers argue that rising the long-term interest
S&P 500 0.851 −0.798** 0.323 −5.741 rate have a negative impact on stock returns by raising financ-
(0.959) (0.238) (0.227) ing costs and reducing corporate profitability (Chen et al., 1986;
Enr −39.851** 2.545 −4.081** 164.273 Ratanapakorn & Sharma, 2007). Asprem (1989) reports a negative
(8.50) (2.15) (2.07) relationship for Germany, Netherlands, Switzerland, Sweden and
Fin 7.692** 0.097 2.266** −44.211
the UK. Humpe and Macmillan (2009) find a significantly negative
(3.54) (0.872) (0.854)
CD 2.401* −1.186** 0.603 −7.841 relationship with the long-term Treasury bond yields. Maysami
(1.30) (0.321) (0.309) and Koh (2000) and Kwon and Shin (1999) find similar results
CS 0.613 −0.773** 0.404** −2.624 for Singapore and South Korea respectively. Mukherjee and Naka
(0.622) (0.155) (0.149)
(1995) find a negative relationship for Japan.
RE −2.131** −0.112 0.571 4.823
(0.817) (0.187) (0.187) The relationship between industrial production as a proxy for
HC 2.462** −1.227** 0.245 −7.571 real economic activity is ambiguous compared to the findings of
(1.14) (0.287) (0.277) previous studies in terms of the sign of influence as can be seen
Ind 4.521** −0.854 1.222** −21.071 in Table 5. While there is a positive and significant relationship
(2.358) (0.594) (0.585)
between industrial production and energy, real estate, and materi-
Mat −29.311** −1.824 −7.944** 154.811
(9.19) (2.29) (2.195) als sectors, the association is negative and significant for financials,
consumer discretionary, health care, and industrial sectors. There
Note: ***␳≤0.001, **␳≤0.005, *␳≤.01.
is also a negative but statistically insignificant relationship with
the S&P 500 and the consumer staples sector. Like most previ-
tion criteria were used, but the outcome does not change for any of ous studies, this paper uses industrial production index as a proxy
the indices. for real economic activity and finds ambiguous relationship for
For Canada, results are substantially different. Both the trace test the US indices. Our results are contradictory to a number of stud-
and maximum eigenvalue test indicate that there is no cointegrat- ies (Abdullah & Hayworth, 1993; Chen et al., 1986; Fama, 1990;
ing relationship between any of the indices and the macroeconomic Mukherjee & Naka, 1995). However, Young (2006) argues that the
variables used in the study. Results do not vary when different lag positive relationship between industrial production and stock mar-
lengths are used as suggested by other information criteria. This ket returns no longer stands when we use more recent US data.
implies that industrial production, money supply, and the long- The long-term relationship for the utilities sector is not illus-
term interest rate fail to explain the stock market in any capacity trated in this paper since it is ambiguous to interpret more than
at least in the long-term. one cointegrating relationship without sound economic theory
(Dibooglu, 1995). Given that all the US stock indices have a cointe-
4.4. VAR/VECM models grating relationship with industrial production, money supply, and
the long-term interest rate, Vector Error Correction models (VECM)
For the United States, as displayed in Table 5, it is observed that have been run in this study for the US. The statistical significance
the equilibrium relation between money supply and the bench- of the coefficient of the error correction term in the VECM frame-
mark index, and six sectors is positive1 . The relationship is positive work establishes the long-run equilibrium relationship between
and significant with the S&P 500, consumer discretionary, con- the stock indices and the macroeconomic variables while the short-
sumer staples, and health care sectors. The relationship is positive run relationship is captured by the significance of the coefficients of
but insignificant with industrials, materials, and real estate sectors. the lagged regressors. In the VECM framework, the coefficient of the
The relationship with financials and energy sectors are negative error correction term represents the speed of adjustment by which
but statistically insignificant. Our results support Abdullah and the dependent variable returns to equilibrium after deviation.
Hayworth (1993), Mukherjee and Naka (1995), Ratanapakorn and Table 6 displays the error correction models for the S&P 500
Sharma (2007) and Humpe and Macmillan (2009) and contra- and all sectoral indices.2 The coefficients of the error correction
dicts with Dhakal et al. (1993). However, these studies are limited terms are significant for the S&P 500, financials, consumer discre-
to the composite index and didn’t investigate the sector specific tionary, consumer staples, real estate, health care, and materials
indices. There are two potential channels through which the pos- sectors. The long-term adjustment coefficient is about -0.054 for
itive relationship could be explained. Mukherjee and Naka argue the S&P 500. This suggests that the deviation of the benchmark
that an increase in money supply acts as a stimulus for economic index from the long-term equilibrium is corrected by about 5.4 %
growth which may increase expected cash flows. Ratanapakorn each month. The same coefficient for financials sector is about -
and Sharma (2007) claim that an increase in money supply lowers 0.022 which implies a correction of about 2.2 % each month. The
interest rates due to increased liquidity which results in portfolio correction is about 5.5 % for consumer discretionary sector, 4.6 %
rebalancing into more financial assets such as equities. However, for consumer staples, 13.1 % for real estate, 2.3 % for health care,
Dhakal et al. (1993) assert that an increase in money supply could and 0.5 % for materials sector.
lead to unanticipated increases in inflation and uncertainty, which For Canada, industrial production, money supply, and the long-
may negatively impact stock prices. term interest rate do not share any cointegrating relationship with
This paper also finds that the association between the long-term the Canadian benchmark S&P/TSX or any of the sector indices.
interest rate and the S&P 500, along with seven sector indices is neg- While the lags of macroeconomic variables have an impact on the
ative for the US as shown in Table 5. The association is negative and indices in the unrestricted VAR framework, there is no long-run
significant with financials, consumer staples, and industrials sec- relationship and the macroeconomic variables used in this study
tors, and negative but insignificant with the S&P 500, consumer have limited power in forecasting stock market trends at least in
discretionary, real estate, and health care sectors whereas the the long-run. Given that most of the companies in the S&P/TSX

1 2
The sign of the normalized cointegrating coefficients are reversed to enable The results of the full VECM with equations for industrial production, money
proper interpretation. For details, see Johansen (1995). supply, and the long-term interest rate are available upon request.
70 E.M. Bhuiyan, M. Chowdhury / The Quarterly Review of Economics and Finance 77 (2020) 62–74

Table 6 Table 6 (Continued)

A. Error Correction Models Enr, Fin, CD, and CS for 2000–2018. B. Error Correction
Models for RE, HC, Ind, and Mat sector for 2000–2018. B.
RE HC Ind Mat
A
Variable Index Index Index Index Index
S&P 500 Enr Fin CD CS
Variable Index Index Index Index Index M1 t-3 −1.562** -.249 -.413 -.579
.515 .304 .364 .443
EC-term -.054** -.002 -.022** -.055** -.046**
M1 t-4 −1.223** – -.229 –
.011 .002 .005 .010 .016
.530 .359
Indext-1 -.001 -.119 .047 .008 .018
LIR t-1 .007 .017 .097** .201**
.067 .069 .069 .066 .068
.068 .041 .049 .062
Indext-2 -.171** -.073 -.151** -.222** .015
LIR t-2 .117* .061 .149** -.001
.066 .074 .066 .064 .066
.071 .041 .051 .062
Indext-3 .061 -.001 .010 .049 -.118*
LIR t-3 -.091 -.011 .152** -.037
.071 .074 .066 .069 .067
.069 .040 .050 .059
Indext-4 – .016 .024 – –
LIR t-4 .128** – .033 –
.074 .066
.065 .049
Indext-5 – -.135** – – –
Constant .002 .003 .002 .006
.074
.007 .003 .004 .005
IP t-1 -.508 .171 .119 -.592 -.201
.448 .661 .637 .529 .346 Note: ***␳≤0.001, **␳≤0.005, *␳≤.01. First number in a cell denotes coefficient of
IP t-2 1.432** 2.931** 2.193** 1.301** .965** the variable while second number denotes std. error.
.418 .658 .634 .498 .342
IP t-3 1.071** 1.762** 1.743** 1.494** .538
.436 .681 .622 .516 .354
are also listed in the US stock exchanges and given strong eco-
IP t-4 – .356 −1.841** – –
.687 .64
nomic ties between Canada and the US, this paper also tests to see
IP t-5 – −2.191** – – – whether the S&P/TSX and Canadian sector indices have a cointe-
.697 grating relationship with the US money supply and the long-term
M1 t-1 -.486* -.277 -.331 -.460 -.337 interest rate.
.294 .448 .418 .353 .238
Both the trace test and maximum eigenvalue test indicate that
M1 t-2 -.623** -.015 −1.391** -.968** -.398
.298 .458 .424 .363 .244 the US money supply and the interest rate are cointegrated with the
M1 t-3 -.641** -.418 −1.551** -.685* -.310 Canadian benchmark as well as all sector indices and the long-term
.294 .454 .432 .359 .240 relationships for which are presented in Appendix C. The results
M1 t-4 – .243 -.427 – –
show that like that of the US, the long-term interest rate have a
.455 .434
M1 t-5 – .226 – – –
negative relationship with the Canadian benchmark index. Results
.449 for money supply are ambiguous, for some sectors it has positive
LIR t-1 .163** .262** .293** .191** -.001 influence, for other sectors it has negative influence. Given that
.042 .064 .059 .050 .033 the industrial production index is no longer a reliable indicator of
LIR t-2 -.012 .013 .018 -.003 .027
real activity in the US, it is dropped when testing the relationship
.042 .067 .063 .051 .034
LIR t-3 .024 -.098 .036 .040 .007 between the US variables and Canadian indices. The reverse sce-
.040 .067 .059 .047 .032 nario, that is whether Canadian money supply and the interest rate
LIR t-4 – -.012 .061 – – have a relationship with the US indices, is also tested. Both the
.065 .057
trace and maximum eigenvalue tests indicate that the Canadian
LIR t-5 – -.066 – – –
.060
macroeconomic variables fail to explain the US indices.
Constant .001 .008 .003 .001 .006* One of the possible reasons of not having a positive relationship
.004 .006 .005 .004 .003 between real economic activity proxies by the industrial produc-
tion index and stock market return is due to the transformation of
B. the US economy from manufacturing to service-based economy.
RE HC Ind Mat
Fig. 1 shows the employment growth in service industries and
Variables Index Index Index Index manufacturing industries since 1939. The figure clearly reflects the
EC-term -.131** -.023** -.006 -.005**
decline in the dominance of manufacturing jobs in recent years.
.025 .011 .007 .002
Indext-1 .072 .005 -.035 -.077 Over the last two decades, employment in the manufacturing
.072 .071 .072 .071 sector has dropped from 18 million to 12 million. In 1990, the
Indext-2 -.122* -.008 -.209** -.063 manufacturing industry employed more workers than any other
.072 .070 .072 .070 sector in 36 states and as of 2014 manufacturing is the dominant
Indext-3 .085 .009 -.002 .031
.073 .070 .069 .071
industry in only seven states (US Bureau of Labor Statistics, 2019;
Indext-4 .125* – .074 – Washington Post, 2014). Today, non-manufacturing sector’s share
.072 .068 of Gross Domestic Product (GDP) is five-and-a-half times bigger
IP t-1 −1.041 .430 .665 -.221 than that of the manufacturing sector. Hence, the change in the
.717 .432 .548 .640
industrial production may not clearly reflect the real economic
IP t-2 2.361** .447 .924* 1.831**
.716 .438 .549 .619 activity.
IP t-3 3.061** -.310 -.108 .841 Moving on to Canada, while this study has found that industrial
.717 .447 .556 .642 production, money supply, and the long-term interest rate have
IP t-4 −1.271* – 2.081** – a long-term equilibrium relationship with stock market indices in
.774 .581
M1 t-1 -.428 -.242 .361 -.637
the United States, such variables failed to explain Canadian stock
.507 .308 .357 .4351 returns over the long-run. In the Canadian context there is an
M1 t-2 −1.271** -.342 .447 -.916** absence of predictability of the indices using money supply and the
.507 .317 .364 .448 interest rate according to Granger (1986) and many others. The lack
of cointegration implies that markets are efficient. More interest-
ingly, when the US variables are used to explain Canadian indices,
 E.M. Bhuiyan, M. Chowdhury / The Quarterly Review of Economics and Finance 77 (2020) 62–74
Fig. 1. Employment Growth in Service Industries versus Manufacturing in the US.
Data Source: Federal Reserve Bank of St. Louis (Original Data: US Bureau of Labor Statistics)
there is a presence of cointegration implying predictive causality
and hence market inefficiency. However, at the same time Canadian
variables fail to explain the US indices in a cointegrating framework.
The discrepancy between the countries could be explained in the
following manner. The monetary policy is much more involved for
the US, and the Federal Reserve, beyond utilizing traditional mone-
tary policy instruments, also engages in non-traditional monetary
policy. So, for the US, according to Dhakal, Kandil, and Subhash
(1993), even if information regarding changes in stock of money
is readily available to traders, the implications of these changes
on the direction of monetary policy may not be readily apparent.
Consequently, information regarding policy changes may not be
reflected in the stock prices. In contrast, the monetary policy for
Canada is straightforward. The Bank of Canada’s only monetary pol-
icy instrument is the target it sets for the overnight interest rate,
which is a market determined rate at which commercial banks lend
funds to each other for a very short period of time. Given that the
Bank of Canada’s strategies are much easier to interpret compared
to the Fed’s policies, it is much easier for the traders to assess the
direction of Canadian monetary policy. As a result, stock prices in
Canada readily incorporate information regarding policy changes
compared to the US. Stocks in the S&P/TSX are inter-listed in the
US exchanges, moreover the Canadian economy is highly integrated
to the US economy with the US being Canada’s largest trading part-
ner; Canada exports around 30 % of its GDP, equivalent to 80 %
of its exports, to the US. International trade is very important to
Canada relative to the US whose exports account for around 10–12%
of its GDP compared to Canada’s 30–35%. Such reasons provided the
motivation to test whether the US variables can explain Canadian
stock returns. It turns out that the US money supply, M1, and long-
term interest rate are cointegrated with all the Canadian sectors
including the composite S&P/TSX. At the same time the Canadian
variables are not cointegrated with the US indices.
The results are not surprising. For instance, Cheung, He, and
Ng, (1997)) find that the US variables are able to explain Euro-
pean and Pacific Rim’s stock market movement, but the reverse
is not true. Similarly, Eun and Shim (1989) report that shocks in
the US stock market are transmitted to other international mar-
kets while no single foreign market can significantly explain the
US stock movements. Conover, Jensen, and Johnson, (1999)) find
that some foreign stock markets are more strongly related to the
US monetary environment than to local monetary conditions and
71
these foreign markets display significantly higher returns when the
Federal Reserve is following an expansive monetary policy. Using
the ARCH framework, Hamao, Masulis, and Ng, (1990)) report the
presence of price volatility spillovers from New York to Tokyo and
London markets but not the opposite. Harvey (1991) finds that vari-
ables that represent the US business cycle can explain foreign stock
returns while Campbell and Hamao (1992) find that the US eco-
nomic variables improve the forecasts of Japanese stock returns.
The above studies highlight the dominant role of the US in the world
economy.
Considering the financial crisis of 2007/2008, this study repeats
the cointegration test using data from January 2010 for the US and
finds that energy, consumer staples, and health care sectors no
longer have a long-term relationship with money supply and the
long-term interest rate. Results are not as robust as before for real
estate, materials, and utilities sectors because the trace test and
the max eigenvalue test show conflicting outcomes. Only the S&P
500, financials, and consumer discretionary sectors have long-term
relationship with money supply and the interest rate according to
both trace and max statistics. The industrial production index was
dropped as the ADF test showed that the series does not contain
a unit root at level form. Results may indicate the possibility that
the 2007/2008 crisis might have fundamentally changed the econ-
omy in such a way that the relationship between the stock indices
and money supply and the interest rate has weakened. As a part
of robustness check, since the US money supply and the long-term
interest rate have a long-term equilibrium relationship with Cana-
dian indices using 2000–2018 data, test is now repeated using data
from January 2010 onward. Results show that US money supply and
the long-term interest rate are no longer able to explain any of the
Canadian stock indices. At the same time, just as before, Canadian
money supply and the long-term interest rate cannot explain any
of the US indices using data from January 2010.
5. Conclusion
This paper finds that there is a long-term equilibrium rela-
tionship between macroeconomic variables that represent money
supply, real economic activity, and long-term interest rate and S&P
500 and all sector indices for the US for the 2000–2018 time period.
Money supply generally has a positive relationship, while the long-
term interest rate has a negative relationship with the indices
72 E.M. Bhuiyan, M. Chowdhury / The Quarterly Review of Economics and Finance 77 (2020) 62–74

supporting the results of earlier studies. The results of industrial Table A1

Description of Stock Market Indices and Macroeconomic Variables.
production with the stock indices are inconclusive. This paper
supports the hypothesis that industrial production is no longer a Index Bloomberg Ticker
Definition
reliable indicator since the US economy has transformed from a US Stock Market Indices
manufacturing-based economy into a service-based economy. No SPX SPX S&P 500
long-term relationship between the same macroeconomic vari- Energy (Enr) SPSUEP Capped Energy Index
ables and various stock indices is found for Canada for the same Financials (Fin) SPSUFP Capped Financials Index
Cons. Disc. (CD) SPSUCDP Capped Consumer
period. Interestingly, the US money supply and the interest rate
Discretionary Index
have a relationship with Canadian indices supporting the notion of Cons. Stap.(CS) SPSUCSP Capped Consumer Staples
the US dominance in the global economy. Index
The same analysis on 2010–2018 data shows that the long-term Real Estate (RE) SPSUREP Capped Real Estate Index
Industrials (Ind) SPSUIP Capped Industrial Index
relationship breaks down for some of the sectors for the US suggest-
Health Care (HC) SPSUHCP Capped Health Care Index
ing a possibility that the financial crisis might have fundamentally Materials (Mat) SPSUMP Capped Materials Index
altered economic relationships. For the same time period, the US Utilities (Uti) SPSUUP Capped Utilities Index
macroeconomic variables fail to explain Canadian indices as well. Technology (Tec) SPSUTP Capped Technology Index
These results should be viewed with caution since the time frame Canadian Stock Market Indices
S&P/TSX SPTSX Benchmark S&P/TSX
is shorter.
Composite Index
The findings of this study clearly suggest that there is an asym- Energy (Enr) SPTSEN Capped Energy Index
metric relationship between macroeconomic variables and stock Financials (Fin) SPTSFN Capped Financials Index
market indices (composite and sectoral) in the US and Canada. Cons. Disc. (CD) SPTSCD Capped Consumer
Discretionary Index
Moreover, any conclusion based on the composite stock market
Cons. Stap.(CS) SPTSCS Capped Consumer Staples
indices further masks the sensitivity of how important macroeco- Index
nomic variables are in shaping stock returns. This study is unique Real Estate (RE) SPTSRE Capped Real Estate Index
in the aspect that it covers all major sectoral indices across the Industrials (Ind) SPTSIN Capped Industrials Index
US and Canada and compares how important macroeconomic vari- Health Care (HC) SPTSHC Capped Health Care Index
Materials (Mat) SPTSMT Capped Materials Index
ables influence those indices. By paying attention to the asymmetry
Utilities (Uti) SPTSUT Capped Utilities Index
in the market across the US and Canada, long-term investors could Technology (Tec) SPTSIT Capped Technology Index
make a better decision for their investments. Macroeconomic Variables
This study could be extended by incorporating other macroe- Variable Definition
Industrial Production (IP) Industrial Production Index
conomic indicators as well as country specific idiosyncratic factors
(Seasonally Adjusted)
to examine their impact on stock market indices. Earlier studies Money Supply (M1) Narrowly Defined Money Supply
have attempted to include short-term interest rate and exchange (Seasonally Adjusted)
rate to explain a single benchmark stock market index of a coun- Long Term Interest Rate (LIR) Long-Term Government Bond
try. Variables such as oil and other commodity prices may have Yields: 10-year

certain impact in explaining stock returns for Canada. Since this

paper investigates ten different indices for the US and for Canada,
attention was given to fewer macroeconomic variables to keep the
analysis focused. A focus on qualitative differences between sectors
not only within a country but also across countries is not addressed
Table A2
in this study. For instance, which sector a company belongs to General Information on the US & Canadian Stock Indices.
is classified through the Global Industry Classification Standard
Index No. of Constituents Total Market Cap. Mean Market Cap.
(GICS). However, within the GICS there are subclassifications. For
instance, the energy sector in the GICS is represented by compa- General Information on the US Stock Indices
nies in energy, equipment, and service industry and by companies S&P 500 505 25,789 51
Enr 31 1492 48
in oil, gas, and consumable fuels. It is possible that the proportion
Fin 67 3529 53
of companies that belongs to one sub-sector compared to another CD 65 2753 42
varies across Canada and the US. In addition, what drives one sector CS 32 1898 59
compared to another may be key in determining which variable to RE 32 661 21
HC 64 3780 59
focus on for investment or other relevant purposes, e.g. oil price
Ind 70 2484 36
could be more important in the energy sector than the long-term Mat 24 615 26
interest rate or money supply. If these variables are controlled for, Uti 29 709 25
sharper insights could be derived. Tec 76 7206 94
General Information on Canadian Stock Indices
S&P/TSX 248 2,238 9
Declaration of Competing Interest
Enr 37 255 7
Fin 27 764 28
None. CD 18 98 5
CS 10 75 8
Acknowledgement RE 22 67 3
HC 8 45 6
Ind 28 236 8
The authors are thankful to Mehmet Dalkir and Philip Leonard
Mat 53 229 4
for their valuable comments in the earlier version of the Uti 16 81 5
manuscript. Tec 16 82 5

Note: In US, market cap in USD billions. (Source: S&P Global). In Canada, market cap.
Appendix A in CAD billions. (Source: TMX Money).

Tables A1, A2, A3, A4

 E.M. Bhuiyan, M. Chowdhury / The Quarterly Review of Economics and Finance 77 (2020) 62–74 73

Table A3 Table B2
Summary Statistics of US Stock Indices & Macroeconomic Variables (Natural Log Phillips-Perron Unit Root test for Canadian Variables for 2000–2018.
form):2000–2018
Index Level First Difference
Index Mean Std. Dev. Min Max
S&P/TSX −2.587 −12.089***
SPX 7.247466 .3014701 6.599993 7.945842 Enr −1.896 −13.650***
Enr 5.322002 .4419402 4.432137 5.977051 Fin −2.521 −11.821***
Fin 4.603877 .3200504 3.48765 5.099531 CD −1.400 −12.218***
CD 4.732602 .4396156 3.872325 5.710311 CS −1.517 −14.760***
CS 5.026783 .3525152 4.437568 5.687236 RE −1.507 −13.913***
RE 5.000024 .2997437 3.939054 5.415433 HC −2.265 −12.413***
HC 4.947539 .3645726 4.418684 5.761136 Ind −2.331 −11.561***
Ind 4.952174 .3433907 4.219934 5.733775 Uti −2.668 −15.567***
Mat 4.884961 .3376732 4.238329 5.535829 Mat −1.490 −15.105***
Uti 4.838592 .2602242 4.167254 5.327551 Tec −4.199*** NA
Tec 4.028656 .4099992 3.161458 4.958394 Macroeconomic Variables Level First Difference
Macroeconomic Variables Mean Std. Dev. Min Max IP −1.259 −13.943***
IP 4.592483 .051341 4.466705 4.682121 M1 −1.733 −13.550***
M1 7.507704 .3929106 6.992648 8.20732 LIR −2.552 −11.200***
LIR 1.186284 .3709966 .4054651 1.874874
Notes: The numerical values represent the PP Z(t) test statistic. ***␳≤0.001,
**␳≤0.005, *␳≤.01. All the level series are in natural logarithmic form.
Table A4
Summary Statistics Canadian Stock Indices & Macroeconomic Variables (Natural Log
Appendix C
Form): 2000–2018.

Index Mean Std. Dev. Min Max Tables C1, C2

TSX 9.329051 .2571359 8.729141 9.69333
Enr 5.361032 .4141019 4.23004 6.095171 Table C1
Fin 5.187586 .3060275 4.569647 5.734958 Cointegration Test for Canadian Indices with US M1 and Long-term Interest Rate for
CD 4.680692 .3107264 4.176539 5.378468 the Period.2000–2018
CS 5.393592 .4836243 4.330338 6.332569
Indices Number of cointegrating Trace Statistic Max statistic
RE 5.216901 .368819 4.376512 5.731462
relationship (r)
HC 4.144203 .3637891 3.271089 5.025918
Ind 4.70727 .3720437 3.998384 5.487449 S&P 500 r=0 44.0746 38.3942
Mat 5.370816 .4174563 4.585274 6.101686 r=1 5.6805** 5.2463**
Uti 5.216558 .2667347 4.32968 5.536152 r=2 0.4342 0.4342
Tec 3.508797 .3698107 2.416806 4.513274 Enr r=0 48.8213 40.3628
Macroeconomic Variables Mean Std. Dev. Min Max r=1 8.4585** 8.0401**
IP 4.688045 .0494051 4.533887 4.78737 r=2 0.4184 0.4184
M1 26.87459 .4408177 26.11981 27.6098 Fin r=0 40.2176 31.0572
LIR 1.13373 .4664905 .0418397 1.846653 r=1 9.1604** 8.8814**
r=2 0.2789 0.2789
CD r=0 61.3384 41.1133
Appendix B r=1 20.2251 20.2077**
r=2 0.0175** 0.0175
CS r=0 53.0328 38.5244
Tables B1, B2
r=1 14.5084** 14.1617
r=2 0.3466 0.3466**
Table B1 RE r=0 46.6012 38.7973
Phillips-Perron Unit Root Test for US Stock Indices and Macroeconomic Variables r=1 7.8039** 7.4772**
for 2000–2018. r=2 0.3267 0.3267
Index Level First Difference HC r=0 44.9597 41.1392
r=1 3.8205** 3.6548**
S&P 500 −2.118 −13.593*** r=2 0.1657 0.1657
Enr −1.835 −15.167*** Ind r=0 54.3442 39.0072
Fin −1.462 −12.489*** r=1 15.3370** 14.8767
CD −2.003 −13.577*** r=2 0.4603 0.4603**
CS −2.750 −13.674*** Mat r=0 47.3180 40.0225
RE −2.196 −11.849*** r=1 7.2956** 7.0876**
HC −2.329 −13.232*** r=2 0.2079 0.2079
Ind −1.234 −14.826*** Uti r=0 46.8717 38.8219
Uti −2.109 −14.072*** r=1 8.0497** 8.0333**
Mat −3.697*** NA r=2 0.0164 0.0164
Tec −2.902 −15.068***
Note: ***␳≤0.001, **␳≤0.005, *␳≤.01.
Macroeconomic Variables Level First Difference
IP −1.733 −12.199***
M1 −1.862 −15.544***
LIR −2.779 −11.938***

Notes: The numerical values represent the PP Z(t) test statistic. ***␳≤0.001,
**␳≤0.005, *␳≤.01. All the level series are in natural logarithmic form.
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