Many academic and professional observers hypothesize a close relationship between stock prices and various monetary variables that are influenced by monetary policy. The best-known mone- tary variable in this regard is the money supply. You will recall from your economics course that the money supply can be measured in several ways, including currency plus demand deposits (referred to as the M1 money supply) and the M1 money supply plus time deposits (referred to as the M2 money supply). The government publishes other measures of the money supply, but M1 and M2 are the best known.7The Federal Reserve controls the money supply through vari- ous tools, the most useful of which is open market operations.
In their classic work on the monetary history of the United States, Friedman and Schwartz thor- oughly documented the relationship between changes in the growth rate of the money supply and subsequent changes in the economy.8Specifically, they demonstrated that declines in the rate of growth of the money supply have preceded business contractions by an average of 20 months, while increases in the growth rate of the money supply have preceded economic expansions by about 8 months.
Friedman suggests a transmission mechanism through which changes in the growth rate of the money supply affect the aggregate economy. He hypothesizes that, to implement planned changes in monetary policy, the Federal Reserve engages in open market operations, buying or selling Treasury bonds to adjust bank reserves and, eventually, the money supply. Because the Fed deals in government bonds, the initial liquidity impact when the Fed buys bonds affects the government bond market, creating excess liquidity for those who sold bonds to the Fed. The result is an increase in bond prices and lower interest rates. Rising or falling government bond prices subse- quently filter down to corporate bonds, and this change in liquidity eventually affects common stocks and then the real goods market. The impact of money supply growth on stock prices is really part of the transmission process whereby money supply affects the aggregate economy. This liquidity transmission scenario implies that the effect of a change in monetary policy initially appears in financial markets (bonds and stocks) and only later in the aggregate economy.
In contrast to a specific monetary series (such as money supply or the monetary base) or an indi- vidual price series (like the federal funds rate or the discount rate), Goldman Sachs has created a composite financial condition series (the Goldman Sachs Financial Conditions Index—
GSFCI).9The GSFCI is a combination of four variables that are expected to reflect the monetary policy environment. The four variables (with weights) are:
1. Real three-month LIBOR (.35)
2. Real A-rated corporate bond yield (.55)
3. Real Goldman Sachs Trade-Weighted Dollar Index (.05) 4. The equity market capitalization/GDP ratio (.05) Financial
Conditions Index Money Supply and the Economy
7For a discussion of alternative monetary series, see John R. Walter, “Monetary Aggregates: A User’s Guide,” Federal Reserve Bank of Richmond, Economic Review (January/February 1989): 53–61.
8Milton Friedman and Anna J. Schwartz, “Money and Business Cycles,” Review of Economics and Statistics 45, no. 1, part 2, supplement (February 1963): 32–78, reprinted in Milton Friedman, The Optimum Quantity of Money and Other Essays (Chicago: Aldine Publishing, 1969): 189–235.
9For a full discussion, see William Dudley and Jan Hatzius, “The Goldman Sachs Financial Conditions Index: The Right Tool for a New Monetary Policy Regime,” Global Economics Paper, no. 44 (New York: Goldman Sachs Global Research, June 8, 2000).
It is contended that this series is superior to any one series and also considers other relevant factors such as the strength of the dollar and the growing importance of the stock market in the economy. The empirical analysis of its relationship to the economy is strong—a one-point increase in the GSFCI is followed (with a three-quarter lag) by about a one-percentage-point decrease in the growth rate of real GDP. The point is, an increase in the GSFCI reflects a tight- ening of the monetary environment based upon a heavy weighting of interest rates—that is, the two interest rate variables constitute 90 percent of the index.
Numerous studies have tested the relationship suggested by this transmission mechanism.
Specifically, do changes in the growth rate of the money supply precede changes in stock prices?
The results of these studies have tended to change over time. The initial studies done in the 1960s and early 1970s generally indicated a strong leading relationship between money supply changes and stock prices.10Such results implied that changes in the growth rate of the money supply could serve as a leading indicator of stock price changes.
Subsequent studies questioned these findings.11Although these studies likewise found a rela- tionship between the money supply and stock prices, the timing of the relationship differed.
These studies found that changes in the growth rate of the money supply did not lead stock prices but consistently lagged stock returns by about one to three months.
Studies in the 1980s examined the relationship of stock returns to anticipated and unantici- pated money supply growth using weekly money supply data.12The results indicated that money changes affect stock prices but stock prices adjust very quickly to unexpected changes in money supply growth. Therefore, to enjoy superior returns, it is necessary to forecast unanticipated changes in money supply growth.
Following more than a decade of limited research on this topic, several recent studies have found that the monetary environment does have an impact on stock returns. A recent set of stud- ies by Jensen, Johnson, and Mercer (JJM) showed that the results of several earlier studies that examined the relationship between some economic variables and stock returns or some company variables and stock returns can be significantly affected by the prevailing monetary environ- ment.13Specifically, JJM showed that the business conditions proxies suggested by Fama and French14(i. e., the term spread, dividend yield, and default spread) have a different effect on Money Supply and
Stock Prices
MONETARYVARIABLES,THEECONOMY,ANDSTOCKPRICES 417
10Studies that generally support this view include Beryl W. Sprinkel, Money and Markets: A Monetarist View (Home- wood, Ill.: Richard D. Irwin, 1971); Michael W. Keran, “Expectations, Money, and the Stock Market,” Federal Reserve Bank of St. Louis, Review 53, no. 1 (January 1971): 16–31; and Kenneth Homa and Dwight Jaffee, “The Study of Money and Stock Prices,” Journal of Finance 26, no. 5 (December 1971): 1015–1066.
11These studies include Richard V. L. Cooper, “Efficient Capital Markets and the Quantity Theory of Money,” Journal of Finance 29, no. 3 (June 1974): 887–908; and M. S. Rozeff, “Money and Stock Prices: Market Efficiency and the Lag Effect of Monetary Policy,” Journal of Financial Economics 1, no. 3 (September 1974): 245–302.
12These studies are found in Lawrence S. Davidson and Richard T. Froyen, “Monetary Policy and Stock Returns: Are Stock Markets Efficient?” Federal Reserve Bank of St. Louis, Review 64, no. 3 (March 1982): 3–12; and R. W. Hafer,
“The Response of Stock Prices to Changes in Weekly Money and the Discount Rate,” Federal Reserve Bank of St. Louis, Review 64, no. 3 (March 1985): 5–14.
13Gerald R. Jenson, Jeffrey Mercer, and Robert R. Johnson, “Business Conditions, Monetary Policy, and Expected Secu- rity Returns,” Journal of Financial Economics 40, no. 2 (February 1996): 213–237; Gerald R. Jenson, Robert R. John- son, and Jeffrey M. Mercer, “New Evidence on Size and Price-to-Book Effects in Stock Returns,” Financial Analysts Journal 53, no. 6 (November–December 1997): 34–42; and Gerald R. Jenson, Robert R. Johnson, and Jeffrey M. Mer- cer, “The Inconsistency of Small Firm and Value Stock Premiums,” Journal of Portfolio Management 24, no. 2 (Winter 1998): 27–36. This research is summarized in Gerald R. Jensen, Robert R. Johnson, and Jeffrey M. Mercer, The Role of Monetary Policy in Investment Management (Charlottesville, Va.: The Research Foundation of the Association of Invest- ment Management and Research, 2000).
14Eugene F. Fama and Kenneth French, “Business Conditions and Expected Returns on Stocks and Bonds,” Journal of Financial Economics 25, no. 1 (January 1989): 23–49.
stock returns depending on the prevailing monetary policy, where monetary policy is indicated by discount rate changes (i.e., declining discount rates imply an easy monetary policy, while ris- ing discount rates imply a restrictive policy). The JJM studies also show that the relationship between stock price returns and both size and the price-to-book value ratio that was found in sev- eral studies only holds during periods of easy monetary policy.15A subsequent study by Thor- becke that examined how stock returns respond to monetary policy shocks indicated that expan- sionary monetary policy increases ex-post stock returns.16 Patelis examined whether shifts in monetary policy affect the predictability of excess stock returns and found that monetary policy variables were significant predictors of future stock returns, although they were not the only rel- evant factors (i.e., dividend yield was also relevant).17
Excess Liquidity and Stock Prices Some analysts contend that excess liquidity is the rel- evant monetary variable that influences stock prices. They define excess liquidity as the year-to- year percentage change in the M2 money supply adjusted for small time deposits minus the year- to-year percentage change in nominal GDP. It is reasoned that the growth rate of nominal GDP indicates the need for liquidity in the economy. If the money supply growth rate exceeds the GDP growth rate, this indicates there is excess money (liquidity) in the economy that is avail- able for buying securities. Therefore, it is reasoned that positive excess liquidity should lead to higher security prices.
Exhibit 12.5 contains a time-series plot of excess liquidity in the United States since 1980.
Our measure is somewhat different from that used by Goldman Sachs—ours is equal to the
15These prior studies include Eugene F. Fama and Kenneth French, “Size and Book-to-Market Factors in Earnings and Returns,” Journal of Finance 50, no. 1 (March 1995): 131–155; and Patricia M. Fairfield, “P/E, P/B, and Present Value of Future Dividends,” Financial Analysts Journal 50, no. 4 (July–August 1994): 23–31.
16Willem Thorbecke, “On Stock Market Returns and Monetary Policy,” Journal of Finance 52, no. 2 (June 1997):
635–654.
17Alex D. Patelis, “Stock Returns Predictability and the Role of Monetary Policy,” Journal of Finance 52, no. 5 (Decem- ber 1997):1951–1972.
1996 1998 2000
1980
Rate (Percent)
6.00 5.00 4.00 3.00 2.00 1.00 0.00 –1.00 –2.00 –3.00 –4.00
6.00 5.00 4.00 3.00 2.00 1.00 0.00 –1.00 –2.00 –3.00 –4.00
1982 1984 1986 1988 1990 1992 1994
Year
EXHIBIT 12.5 TIME-SERIES PLOT OF “EXCESS LIQUIDITY” IN THE UNITED STATES: 1980–2001
annual growth rate of the M2 money supply minus the annual growth rate of nominal GDP. As shown, it was almost always negative during the period 1991 into 1996, yet U.S. stocks experi- enced outstanding returns during 1995–1999. This inconsistency could be caused by the exis- tence of positive excess liquidity in some of our major trading partner countries, such as the United Kingdom, Germany, and Japan, who tend to invest in our stocks. This significant non- U.S. liquidity helped the U.S. stock market continue to rise in 1995–1999.
Chen, Roll, and Ross examined equity returns relative to a set of macroeconomic variables.18 They found the following variables to be significant in explaining stock returns:
➤ Growth in industrial production
➤ Changes in the risk premium
➤ Twists in the yield curve
➤ Measures of unanticipated inflation
➤ Changes in expected inflation during periods of volatile inflation
The authors did not attempt to use these variables to predict market returns, but suggested that these variables were important in explaining past stock market returns.
Because this chapter is concerned with the macroeconomic analysis of security markets, we should examine the macroeconomic impact of inflation and interest rates. We have noted throughout the book the critical role of expected inflation and nominal interest rates in deter- mining the required rate of return used to derive the value of all investments. We would expect these variables that are very important in microeconomic valuation to also affect changes in the aggregate markets.
Inflation and Interest Rates Exhibit 12.6 contains a plot of long-term interest rates and the year-to-year percentage change in the consumer price index (CPI, a measure of inflation).
This graph demonstrates the strong relationship between inflation and interest rates. We con- tended in our earlier discussion that when investors anticipated an increase in the rate of infla- tion, they would increase their required rates of return by a similar amount to derive constant real rates of return. The time-series graph of the promised yield of Aaa corporate bonds and the annual rate of inflation in Exhibit 12.6 confirms the expected relationship overall but also indi- cates an imperfect relationship between interest rates and inflation. If the relationship was per- fect and investors were accurate in their predictions of future inflation, the difference between the interest rate and the inflation rate (the spread between them) would be fairly constant, reflect- ing the real return on corporate bonds. As shown, the spread between these two curves changes over time.
Exhibit 12.7 plots this spread between bond interest rates and inflation and demonstrates the following results. Although the two curves generally move together, during some periods (1975–1979) the inflation rate exceeded the yield on the bonds, which implies that during these periods investors received negative real returns on corporate bonds. In contrast, during 1983–1985, the real rates of return on these high quality bonds were in the 8 to 10 percent range, which clearly exceeds what most investors would expect on very low risk bonds.
This change in spread does not mean that there is not a relationship between inflation and inter- est rates; it only shows that investors are not very good at predicting inflation. Recall that the the- oretical relationship is between expected inflation and interest rates, which is in contrast to these Inflation, Interest
Rates, and Security Prices Other Economic Variables and
Stock Prices
MONETARYVARIABLES,THEECONOMY,ANDSTOCKPRICES 419
18Nai-Fu Chen, Richard Roll, and Stephen A. Ross, “Economic Forces and the Stock Market,” Journal of Business 59, no. 3 (July 1986).
data that reflect actual inflation. Apparently, investors underestimated the rapid increase in the rate of inflation during the period 1978–1980, which means that they employed a discount rate that was too low and, therefore, they overpayed for bonds and experienced negative real returns. In contrast, they overestimated the rate of inflation during 1980–1983 when inflation declined rapidly, so they underpaid for bonds and experienced abnormally high real rates of return.
1974 18.00 16.00 14.00 12.00 10.00 8.00 6.00 4.00 2.00 0.00
18.00 16.00 14.00 12.00 10.00 8.00 6.00 4.00 2.00 0.00 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000
Year
Rate (Percent)
AAA Yield
Rate of Inflation
EXHIBIT 12.6 TIME-SERIES PLOT OF THE PROMISED YIELD OF MOODY’S AAA CORPORATE BONDS AND INFLATION: MONTHLY 1974–2000
Reprinted with permission from Moody’s Investors Service.
1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 Year
12.00 10.00 8.00 6.00 4.00 2.00 0.00 –2.00 –4.00
12.00 10.00 8.00 6.00 4.00 2.00 0.00 –2.00 –4.00
Rate (Percent)
EXHIBIT 12.7 SPREAD BETWEEN THE YIELD OF MOODY’S AAA CORPORATE BONDS AND INFLATION:
MONTHLY 1974–2000
Reprinted with permission from Moody’s Investors Service.
Interest Rates and Bond Prices The relationship between interest rates and bond prices is clearly negative because the only variable that changes in the valuation model is the discount factor. Specifically, the expected cash flows from a straight noncallable bond would not change, so an increase in interest rates will cause a decline in bond prices and a decline in interest rates will boost bond prices. For example, if you own a 10-year bond with a coupon of 10 percent, when interest rates go from 10 percent to 12 percent, the price of this bond will go from $1,000 (par) to $885. In contrast, if rates go from 10 percent to 8 percent, the price of the bond will go from $1,000 to $1,136.
The size of the price change will depend on the characteristics of the bond. A longer-term bond will experience a larger price change for a change in interest rates.19Therefore, we can anticipate a negative relationship between inflation and the rates of return on bonds because inflation generally has a direct effect on interest rates; and, in turn, interest rates have an inverse effect on bond prices and rates of return. One example of empirical verification for this negative relationship is provided in Exhibit 3.16, which shows a correlation of –0.17 between inflation and rates of return on long-term investment-grade bonds.
Inflation, Interest Rates, and Stock Prices The relationship between inflation, interest rates, and stock prices is not direct and consistent. The reason is that the cash flows from stocks can change along with inflation and interest rates, and we cannot be certain whether this change in cash flows will augment or offset the change in interest rates. To demonstrate this, consider the following potential scenarios following an increase in the rate of inflation and the effect on stock prices based on the DDM.
1. The Positive Scenario. Interest rates rise due to an increase in the rate of inflation, and corporate earnings likewise experience an increase in growth because firms are able to increase prices in line with cost increases. In this case, stock prices might be fairly stable because the negative effect of an increase in the required rate of return (k) is partially or wholly offset by the increase in the growth rate of earnings and dividends (g), which means that the returns on stock increase in line with the rate of inflation.
2. Mild Negative Scenario. Interest rates increase due to inflation, but expected cash flows change very little or not at all because firms are not able to increase prices in response to higher costs. This would cause a decline in stock prices similar to what happens with a bond. The required rate of return (k) would increase, but the growth rate of dividends (g) would be constant. As a result, the k–g spread discussed in Chapter 11 would widen and stock prices would decline.
3. Very Negative Scenario. Interest rates increase due to inflation, while cash flows decline because the inflation that caused the rise in interest rates has a negative impact on earn- ings. For example, during 1981 to 1982, interest rates increased and remained high during a period of economic decline, which caused sales and earnings to decline. Alternatively, one can envision a period of inflation wherein the costs of production increase, but many firms are not able to increase prices, which causes a decline in profit margins. The impact of this set of events can be disastrous. Given this scenario, stock prices will experience a significant decline because k will increase as g declines, causing a large increase in the k–g spread.
In contrast to these scenarios, you can envision a comparable set of scenarios when inflation and interest rates decline. The relationship between inflation, interest rates, and stock prices is not as direct or consistent as the relationship between interest rates and bonds. The point is, the MONETARYVARIABLES,THEECONOMY,ANDSTOCKPRICES 421
19Chapter 19 contains a detailed discussion of the specific variables that influence bond price volatility.
20Studies on the topic of inflation and common stocks include Frank K. Reilly, “Companies and Common Stocks as Infla- tion Hedges,” New York University, Center for the Study of Financial Institutions, Bulletin (April 1975); Jeffrey F. Jaffe and Gershon Mandelker, “The ‘Fisher Effect’ for Risky Assets: An Empirical Analysis,” Journal of Finance 31, no. 2 (May 1976): 447–458; and Eugene F. Fama, “Stock Returns, Real Activity, Inflation and Money,” American Economic Review 71, no. 4 (September 1981). For an analysis of the factors that cause this relationship between inflation and stock returns, see Frank K. Reilly, “The Impact of Inflation on ROE, Growth and Stock Prices,” Financial Services Review 6, no. 1 (1997): 1–17.
21Studies that examined alternative industries as inflation hedges include Stephen P. Ferris and Anil K. Makhija,
“A Search for Common Stock Inflation Hedges,” Review of Business and Economic Research 22, no. 2 (Spring 1987):
27–36; and Frank K. Reilly, David J. Wright, and Robert R. Johnson, “An Analysis of the Interest Rate Sensitivity of Common Stocks,” Financial Management Association Meeting (October 2000).
22The other Goldman Sachs publications used include The International Economics Analyst, Financial Markets Per- spectives, Investment Strategy Highlights, Japan Investment Strategy Highlights, and The U.K. Economics Analyst.
effect of interest rate changes on stock prices will depend on what caused the change in interest rates and the effect of this event on the expected cash flows on common stock.
Notably, the actual relationship between inflation, interest rates, and stock prices is an empir- ical question and the effect varies over time. Therefore, although there has generally been a sig- nificant negative relationship between inflation, interest rates, and the returns on stock, as shown in Chapter 3 (Exhibit 3.16), this is not always true.20In addition, even when it is true for the over- all market, certain industries may have earnings, cash flows, and dividends that react positively to inflation and interest rate changes. In such an instance, their stock prices would be positively correlated with inflation and interest rates.21
There is ample evidence of a strong and consistent relationship between economic activity and the stock market, although stock prices consistently seem to turn from four to nine months before the economy does. Therefore, to project the future direction of the stock market using the macro- economic approach, you must either forecast economic activity about 12 months ahead or exam- ine economic indicator series that lead the economy by more than stock prices do.
The results of a study with the leading indicator series indicated that they cannot be used to time stock selection. Past studies of the relationship between the money supply and stock prices have indicated a significant relationship but typically found that stock prices generally turn before the money supply does. Most recent research has indicated that the monetary environ- ment does have a significant impact on stock market returns and impacts other relationships with stocks. Therefore, you should be aware of the monetary environment when projecting market returns.