Mixon and Colleagues Publish New Study on Macroeconomic Dynamics of Stock Market Cycles

A rational stock market utilizes all available information to forecast real economic activity. If it does so well, expectations for future economic conditions get incorporated into current stock prices, and investors may see stock market performance as a predictor of real economic activity. Stock markets also react to changes in future economic prospects. These reactions can lead to market fluctuations and even crashes. Thus, understanding the interactions between the economy and stock markets is crucial—economic fundamentals directly impact stock performance, and stock indices can signal upcoming economic shifts. For example, rising output increases investment returns, which, in turn, stimulates capital spending. An efficient market anticipates this and rallies ahead of real economic changes. Conversely, a bleak economic outlook may lead to downward revisions of future profits. Firms might then pause investing while awaiting clarity. This can reduce capital spending and output. Here, stock market declines precede drops in real economic activity.

     The above points to the intricacies of the associations between the stock market and the macroeconomy. A new study by Turner College economist Frank Mixon and his colleagues Puneet Vatsa of Lincoln University, Kamal Upadhyaya of the University of New Haven and Hem Basnet of Methodist University is devoted to analyzing these associations for the U.S. stock market and the macroeconomy. More specifically, the study combines the Hamilton filter with time-difference analysis in order to examine the lead-lag relationships between three stock indices—the Standard & Poor’s 500, the Dow Jones Industrial Average, and the Nasdaq Composite—and three key macroeconomic variables, namely the Industrial Production Index, total non-farm employment, and the Consumer Price Index. The findings of the study, set to appear in an upcoming issue of International Advances in Economic Research, point to a strong, positive correlation between U.S. stock indices and the business cycle between 1990 and 2020, with stock markets typically lagging industrial production by one to three months. Mixon et al.'s analysis also reveals that the associations between the U.S. stock market indices and inflation have changed noticeably over time—in the 1980s and 1990s, they were negatively correlated, whereas, during the 2000s and 2010s, they were strongly and positively correlated. The study also presents some evidence of a negative association between the real economy and stock market cycles during the 1980s. Unsurprisingly, the three stock indices have exhibited strong co-movement throughout the last 40 years.