Fluctuations in security markets are related to changes in expectations for the aggregate economy. The prices of government and investment-grade corporate bonds are determined by the level of interest rates, which is influenced by overall economic activity and RBI policy.
Aggregate stock prices reflect investor expectations about corporate performance in terms of earnings, cash flows, and the required rate of return by investors. All of these expectations are heavily impacted by the economic outlook.
Given the expected relationship between security markets and the economy, this section has four subsections: (1) Relationship between the economy and stock prices, (2) Economic series that provide specific insights related to the stock market, (3) Macroeconomic impact of inflation and interest rates on security prices, and (4) Additional factors
6.2 Economic Activity and Security Markets
In its monitoring of business cycles, the National Bureau of Economic Research (NBER) has examined the relationship of alternative economic series to the behavior of the entire economy and has classified numerous economic series into three groups: leading, coincident, and lagging indicator series. Further, extensive analysis of the relationship between the economy and the stock market has shown that stock prices are one of the better leading indicator series.
There are two possible reasons why stock prices lead the economy:
Stock prices reflect expectations of earnings, dividends, and interest rates. As investors attempt to estimate these future variables, their stock price decisions reflect expectations for future economic activity, not past or current activity.
The stock market reacts to various leading indicator series, the most important being corporate earnings, corporate profit margins, interest rates, and changes in the growth rate of the money supply. Because these series tend to lead the economy, when investors adjust stock prices to reflect these leading economic series, expectations for stock prices become a leading series as well.
6.3 Economic Series and Stock Prices
As noted, because research has documented that peaks and troughs in stock prices tend to occur prior to peaks and troughs in the economy, our consideration of relevant economic series concentrates on two broad categories of economic series that likewise lead the economy and should provide some insights regarding the future trend of stocks. The first are sets of economic series suggested by the National Bureau of Economic Research. The second are alternative monetary series influenced by the Reserve Bank of India.
6.4 Return Calculation of Portfolio ( Two Assets)
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 monetary variable is the money supply. You will recall from your economics course that there are numerous measures of the money supply and the Reserve Bank of India controls the money supply through various tools like CRR, SLR, Reserve Ratios & Open Market Operations
Research by Friedman and Schwartz (1963) documented that declines in the rate of growth of the money supply have preceded business contractions, while increases in the growth rate of the money supply have consistently preceded economic expansions.
Friedman (1969) suggests a transmission mechanism through which changes in the growth rate of the money supply affect the aggregate economy. He analysed that, to implement planned changes in monetary policy, the Central Bank engages in open market operations, buying or selling Treasury bonds to adjust bank reserves and, eventually, the money supply.
Because the central bank deals in government bonds, the initial liquidity impact when the Central bank buys bonds affects the government bond market, creating excess liquidity for those who sold bonds to the central bank. The result of the bond purchases is an increase in bond prices and lower interest rates.
Rising government bond prices subsequently filter down to corporate bonds, and this change in liquidity eventually affects common stocks and then the real goods market.
There is the opposite effect if the central bank sells bonds to reduce bank reserves and the money supply. The impact of changes in 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.
6.5 Inflation, Interest Rates and Stock Prices
The relationship among inflation, interest rates, and stock prices is not direct and consistent. The reason is that the expected 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 after an increase in the rate of inflation and the effect of this on stock prices based on the Dividend Discount Model: (Recall- Formula for dividend Discount model- DPS1/ ke-g where, DPS1 = Expected Dividends one year from now (next period) ke= Required rate of return for equity investors g = Growth rate in dividends forever)
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 causes an increase in the value of stocks. As a result, the returns on stock increase in line with the rate of inflation—that is, stocks would be a good inflation hedge.
2. Mildly negative scenario- Interest rates and the required return k increase due to inflation, but expected cash flows continue to grow at the prior rate assuming small increases in prices at rates below the increase in the inflation rate and cost increases. 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 would widen and stock prices would decline.
3. Very negative scenario- Interest rates and the required return k increase due to inflation, while the growth rate of cash flows declines because during the period of inflation the costs of production increase, but many firms are not able to increase prices at all, which causes a major decline in profit margins. Given this scenario, stock prices will experience a significant decline because k will increase and g will decline, 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 among inflation, interest rates, and stock prices is not as direct or consistent as the relationship between interest rates and bond prices. The point is, the 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 for alternative common stocks.