Vaman

Perhaps a rank generalisation as that might be taught in Univ of Timbuctoo or Swaziland (no offense to either), but in the absence of data on other economic variables and understanding of the equity market that'd be plain stupid.
Overly inflated market indices propped up by speculative trades reflect nothing of the economic fundamentals of the economy.

Observer

Re: 'Vaman' at 05:49 PM Post#76

"Perhaps a rank generalisation as that might be taught in Univ of Timbuctoo or Swaziland (no offense to either), but in the absence of data on other economic variables and understanding of the equity market that'd be plain stupid. Overly inflated market indices propped up by speculative trades reflect nothing of the economic fundamentals of the economy"

Nevertheless, it happens to be a "rank generalisation" taught in prestigious universities all over the world in courses on Economic Forecasting or Financial Market Analysis and is backed up by peer-reviewed studies published over the decades. Since people after taking these courses rarely come out thinking otherwise due to the soundness of the rationale given to them for this phenomenon which is widely accepted by economists & financial analysts throughout the world, I must conclude that you have not had the benefit of this information before.

I can provide some internet links if they would help you.

Sameer

Thanks for catching it, I made a mistake when saying follows, I ment is followed by, BUT even then i was not wrong, both are correct actually in technical terms and it really depends how you wish to look at it, i dont have much time to type an essay so here is a simple explanation through link, sorry i am lazy...

hint: interest rates and the Central Bank and say commodity prices....

http://www.colorado.edu/Economics/co.../section8.html

some argue that the economy leads the stock market, while others maintain the stock market leads the economy. Actually, they are both correct.

First, let us begin with a brief review of some critical information from the previous section. We studied business cycles, or the fluctuation in economic growth over time. The phases of a complete business cycle could be condensed into the follow major parts:

We begin with a period of resumed economic growth after a recession. Aggregate demand (GDP) growth is suddenly increasing, and may be spurting beyond the consist year-to-year increase in our nation's productive capacity, or increase in aggregate supply. But even with rapid rates of aggregate demand growth, inflation is not a problem due to the excess capacity or slack present in the economy.


As the business cycle continues the economy enters its mature phase (although in turbulent times, this step will probably be skipped altogether). For the past several years, the U.S. economy has been at what is considered to be full-employment. In addition, growth has remained positive, but non-inflationary. The non-inflationary growth phase of the business cycle is characterized by full employment and growth of aggregate demand about equal to the expansion of aggregate supply. The steady annual increase in aggregate supply determines the maximum attainable level of non-inflationary GDP growth.


Next we move into the inflationary growth phase where the economy has reached full employment, and now aggregate demand growth picks up stream (or remains rapid if the second step was skipped) and begins to run ahead of the normal increase in aggregate supply and productive capacity. This was shown graphically as the aggregate demand curve shifts into the steep or vertical range of the aggregate supply curve.


Increasing inflation rates attracts the attention of economic policy makers, especially the Federal Reserve Board, who slam the brakes on growth (we will cover the details in a later section). Since finding just the right amount of policy to dampen growth is extremely difficult, we assume that aggregate demand growth decelerates rapidly, leading to:


A recession, where aggregate demand (GDP) actually falls. As unemployment rates rise, and excess capacity builds, inflation rates tumble and economic policy makers switch from the brakes to the accelerator and we move back to step 1 above.
In this section we turn our attention to how financial markets react to the above. Presently, the key link of financial markets to the economy is the Federal Reserve Board (Fed) and its policy towards interest rates. We will cover the details later in this course, but for now we just need to know that the Fed can, at its discretion, either raise or lower interest rates. And if the Fed feels that inflation is on the rise, it will raise interest rates to slow economic growth, and just the opposite if it feels that economic growth is too weak. A critical point to comprehending this material is to understand the difference between a reactionary policy and a policy that anticipates events.

A reactionary policy implies that the Fed will react to economic events and then take action. If inflation has risen to an undesirable level, the Fed will slow the growth in aggregate demand by raising interest rates. The idea is that the Fed will wait until the event occurs (inflation rises) before taking action (raising interest rates).

During the 1980s, the Fed developed complex computer models that help it better understand the economy. With its much improved understanding of economic conditions the Fed has been able to successfully switch from a reactionary economic policy to one that anticipates changes in the economy.

An anticipatory policy involves the use of leading indicators to forecast changes in the economy. An example of a leading indicator is the prices of different commodities. Commodities are items such as oil, copper, aluminum, steel and other materials used in the production of goods. Consider the case where inflation as measured by the CPI remains steady. As you recall, the CPI measures the prices that consumer pay for finished goods such as cars, televisions, and clothing. In contrast to the steady CPI, assume that commodity prices are increasing. Higher commodity prices increase the production costs of final consumer goods. Higher production costs leads to an inward shift of the firm's supply curve and eventually higher prices for final goods and a rise in the CPI as firms pass higher input prices on to the consumer of the final good.

The Fed now tries to anticipate future changes in the CPI and inflation rates by closely tracking leading indicators such as commodity prices and other discussed in this section. If by the judgment of the Fed, the consensus of leading indicators points to a serious potential for future rises in the inflation rate, the Fed may take action to slow economic growth and dampen inflationary pressures before inflation actually increases. The Fed's goal is to smooth out the business cycle, avoiding inflationary spikes and the more extreme reactionary policy that is necessitated when inflation rates do rise.

Now back to financial markets. The key to understanding long run movements in financial markets is to realize that financial markets respond to changes in leading indicators, since changes in leading indicators may prompt the Fed to take action. There is a direct linkage between bond prices and market interest rates. Higher interest rates lead in turn to lower bond prices. And although the linkage between stock prices and interest rates is not a direct one, in general expect stock prices to fall when interest rates rise. Even more importantly, bond and stock prices will tumble when they expect or anticipate a rise in future interest rates.
Financial analysts and the Fed are basically tracking the same data. As a result, financial analysts are trying to read the tea leaves and predict how the Fed will respond in its next policy meeting to the economic data. It is a guessing game. Financial analysts try to predict Fed behavior, and take action before the Fed actually does. For example, if the leading indicators point to higher inflation rates down the road, a financial analyst will conclude that the Fed is likely to raise interest rates in the next month. Knowing that higher interest rates will lead to a correction in bond and stock prices, the analyst goes ahead and sells part of his or her portfolio immediately. Since all financial analysts have access to the same information, and most will reach the same conclusion (the penalty for being left behind the pack can be expensive), stock and bond markets may react violently to a single bit of economic news.

This helps to explain part of the volatility of stock markets - expectations change from hour-to-hour and day-to-day as new economic information becomes available. Each piece is used to partially complete the puzzle of what the Fed is going to do at its next meeting.

"One area where individual investors have an advantage over us professionals is that we drive ourselves crazy trying to figure out what the latest 8:30 a.m. report means. We analyze it and overanalyze it."
Abby Cohen of Goldman Sachs - Fortune, June 9, 1997

There are thousands of mutual funds, pension funds, banks and other institutions where an individual may be responsible for a portfolio worth billions of





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It is argued that the stock market is highly corrolated to the long run growth economy through the liquidity effect and much research has shown that the stock market may granger cause economic growth while some Nobel loreates have downplayed this relationship but they are development economists soo....

Put my post in context to what Indiaforu wrote as well, econometrics, time series analysis in particular is the corner stone of forecasting but certainly things are much more complicated than your basic what leads what...

Sameer

The relatioship in the short run however is very tricky, certainly when forecasting financial markets in the short run, there is no general agreement on wether it SR economic growth news that affects stock market growth or the other way around.
eg: Sept 11th- Economists and the feds predicted billions and a negative effect to gdp growth and the stock market investors became quite nervours while a rally eventually resulted due to nationalism.

Long term expectations of high oil prices may affect LR stock market growth though but even this has yet to be proven.

But take Mumbai flooding, no effect on the BSE.

Sameer

There are certainly cases where investors hear news about gdp growth forecasts for the next quarter and this affects the stock market, ie growth expectations affect stock markets but here you would be getting into complex time series analysis and i dont want to get into that, to damn boring.


In effect, expectations of higher future growth (or even if growth was strong this quarter, i may expect the feds to be more inclind to raise interest rates next month and i may notice the stock market change) in general and higher expected consumer demand affects the stock market while the stock market granger causes LR growth.

hope i cleared myself up for the record but what Granger causes what is a tricky affair but what is more factual is that both move together while i would not underline the words "leading indicator" too strong and i may be fired, one thing i learned is always to cover yourself when presenting your analysis to the boss.

Sameer

that is a valid point and you may find development economists to agree with you but what do they know......


However the BSE is beyound speculation and I have no idea why people are claiming that, what happened in the past is not happening now, the economy is quite different and it is high demand that is driving companies toget bullish or should i say expectations which i differentiate from speculation.

Sameer

There are different and very complicated expectations models for time series analysis where one must analyse auto regressive and moving average processes where the term rho must be estimated and white noise minimized, if anyone is interested we can spend some more time talking about it.

Critisisms of forecasting, it has to be said, however include the famous Lucas critique, serial corrolation, autocorrelation, misspecification, multicolinearity, failing the DIcky Fuller test etc etc etc

Vaman

Huh? development economists? WTF does that have to do with it?

indianguy4u

Sameer quit explaining the rise in SE as related to economy etc. 99 % of SE is spculation.

__________________
Hala Madrid!!

Sameer

no it is not


Verman

Some development economists have suggested that stock markets are pure speculation and that there is no relationship btw growth and stock markets...

indianguy4u

This is absolutely corrrect.

Sameer

On the contrary it is absolutely wrong and I have been working in the field for the last 3 years and people have been diversifying portfolios for at least 60 years now.



guess i am off the hook

however i tell you what, present your own mathematical/statistical prrof as to why a stock market is based on speculation at 99%, even the BSE, go ahead, and I tell you what, i guarantee you a job paying you 200000 USD a year and a Nobel prize.

Well i can guarantee you the job, the Nobel prize will come.

Vaman

Hold on to your horses sam, not only are you getting ahead of yourself.. you are getting incomprehensible for many members on the board.
First, READ.
I am not saying that theres no relationship between economic growth and stock market performance. What I did say was that I dont consider stock markets, in the absence of data on other economic variables, is a good indicator of the economy as whole.
Second, I dont think you have clue about what developmental economics is, so lets not drag it here.

Its like this :
If event A occurs and another event B occurs later on, you can draw as many regressions as you want and infer that the A leads to B. However just because they both occur is no reason to believe that B also leads to A. Its a logical fallacy. Its a common mistake but its amatuerish none the less.

The same applies at a fundamental level here as well and is logically conisistent as well. If an economy does well, stockmarkets being a small subset of the economies would also be expected to do well. Better overall economic performance leading to better stock performanc is still a valid inference to draw.
But stellar stock performance in itself leading to economic growth ? No way.!!
Couple of reasons:
* A stock market is a miniscule part of the overall economy and does not represent all participants in the economy. GDP/GDP growth is a far superior benchmark to judge a economy, coz very simply it takes into account all partcipants in the economy.
* A stock market index (the one that people normally see and jump and down about) is an even smaller representation of the economy. Typically its just 40-50 companies making up an index. How can just their performance an adequate representation of the entire market?
* A huge proportion of the economic activities are not financed by equity but by debt instruments. In India the debt markets is larger than the equity markets by many folds.
* The price of a scrip at any given time is usually not the true value of a firm. Any banker who values a firms does it on the basis of the firms future cash flows discounted by a particular rate. This rate is the risk-free rate of a government bond and not market yields(which would have been the case if the stock markets were to lead the economy).
* Free markets and the efficient market hypothesis tells us that if the stockmarkets operate truly effieciently then they would never produce returns in excess of or returns less than that of what the economy produces. In other words market returns would converge to overall economic growth.

and so on...

indianguy4u

Three Qs
1] Why did Black Monday happened?
2] Why has BSE has reached 8500 levels?
3] Why two big correction [165 & 175] happened recently?

Sameer

Let me address your first part.

I have a Masters in Financial Economics, at least i understand what development Economics say and i can get as technical as you wish on the matter

"If event A occurs and another event B occurs later on, you can draw as many regressions as you want and infer that the A leads to B. However just because they both occur is no reason to believe that B also leads to A. Its a logical fallacy. Its a common mistake but its amatuerish none the less."

It would be had causality tests not been invented but I am sure you knew this.




Now about what causes what does B cause A or A cause B, you must know what Granger causality tests are all about as well I presume because that answers that question.