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A R T I C L E S
WHAT MOVES STOCK PRICES AND HOW?
BY Anuradha Guru*
Introduction
The daily movement of stock prices is no less than a conundrum for a layman who is unable to comprehend the reasons behind these gyrations. What most amateur market watchers/players understand is that the market price of a
particular share is dependent on the demand and supply for that particular scrip. If the market participants are confident about the fundamental strengths of a company which has had a track record of good performance or has the
potential to do well in the future, the demand for the shares of the company increases and players are willing to
pay higher prices to buy the share. And since the number of shares issued by the company is constant at a given
point in time, any increase in demand would only increase the market price.
However, there are many other factors not directly related to the company or its sector that have their impact of
stock prices. Movements of stock prices are seen to depend on macroeconomic factors; domestic and international
economic, social or political events; market sentiments / expectations about future economic growth trajectory or
critical budgetary, monetary and fiscal policy announcements etc. The stock market capitalizes the present and
future values of growth opportunities while evaluating the growth of all sectors in the economy. In a sense stock
markets can really be regarded as the pulse of the economy as they reflect every action taken by the economic and
political agents almost instantly. A stock market transaction of buy or sell is actually a purchase or sale of expectations representing market players’ beliefs about the economy.
This article attempts to demystify the links between stock market movements and various other factors mentioned
above, examining the channels through which they affect stock prices. It also sites some important empirical studies which have tested these linkages and the direction of their effects on stock prices worldwide and in the Indian
context, wherever such studies are available.
The rest of the paper is organized as follows: section I deals with effects of macroeconomic variables on stock market movements; section II examines the impact of macroeconomic policy announcements on stock market returns
and section III looks at the channels through which expectations, sentiments, political developments, international
events etc, transmit their impact to stock market volatility.
Section I:
Macro economic variables and stock market movements
The relationship between macro economic factors and stock market movements has dominated the academic and
practitioners’ literature since long. Some fundamental macroeconomic variables such as growth rate of the economy, exchange rate, interest rate, industrial output and inflation have been argued to be determinants of stock
prices. This has motivated many researchers to investigate the dynamic relationship between them. For example,
Fama (1981) documents a strong positive correlation between common stock returns and real economic variables
like capital expenditures, industrial production, real GNP, money supply, lagged inflation and interest rates. Chen,
Roll and Ross (1986) find that the changes in aggregate production, inflation, short-term interest rates, maturity
risk-premium and default risk-premium are the economic factors that explain the changes in stock prices.
Below we examine the impact of each of these individual macroeconomic factors on stock prices.
Economic growth
Stock markets aid economic growth and development through the mobilization and allocation of savings, risk diversification, liquidity creating ability and corporate governance improvement, among others. Improving the efficiency
and effectiveness of these functions, through prompt delivery of their services can augment the rate of economic
growth. This relationship also works the other way round, viz. economic growth; implying increased economic activity, rising employment, industrial production, wholesale /retail sales and income levels; moves stock prices in the
upward direction.
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*The author is with NSE. Views expressed in the article are that of the author alone.
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Sawhney, Emmanuel and Feridun (2006) examined the long run relationship between economic growth and stock
prices for Canada and the United States. Their results reveal that economic growth and stock prices share long run
equilibrium relationship for both Canada and the U.S. Further, for the U.S., causality runs from economic growth
to stock prices but not vice versa. However for Canada, the results reveal that there is a bi-directional causality
between economic growth and stock prices.
The effect of GDP releases on equity prices is difficult to predict in part because there are two potentially offsetting effects. Stronger than expected GDP growth implies potentially stronger dividend growth and higher equity
prices, however, the accompanying inflation and interest rate concerns tend to have a negative effect on equity
prices. Several studies in the macroeconomics and finance literature have examined this question with sufficiently
large datasets to allow for more rigorous methods. These studies test for the effect of the surprise component of
various macroeconomic releases (i.e. actual less consensus or survey estimates) on asset price movements on that
day, or intraday around the time of the release (for example see Bernanke and Kutter (2003), and Fair (2003)) . In
general, these studies tend not to find a significant effect of the GDP release news and equity price movements
due to the offsetting effects noted above and difficulty measuring the true “news” contained in the data release.
Rigobon and Sack (2006) using data from 1994 to 2006, find no significant effect of advance GDP release surprises
on equity prices. However, they do find a slightly positive effect that is statistically significant when they use a
more advanced econometric method which controls for censoring effects. The coefficient was tiny, so it would
take a large surprise to generate even a small movement in stock prices according to their findings.
Industrial production
The positive relation between industrial production and stock prices is quite apparent. Higher industrial production
numbers indicate a healthy economy and induce “feel good” sentiments among stock market investors. Current
period’s positive data also increases expectations of better future performance by the industry as well and drives
up stock prices in general and prices of stocks of the particular industrial sectors that have performed or are expected to perform better than the average.
Fama (1990) shows that monthly, quarterly and annual stock returns are highly correlated with future production
growth rates. He argues that the relation between current stock returns and future production growth reflects information about future cash flows that is impounded in stock prices. The same results are also found by Schwert
(1990) who uses a larger data period for his study.
In a study of Indian stock markets, Agrawalla?and Tuteja?(2008) examine the causal relationships between the
share price index and industrial production. The study reports causality running from economic growth proxied by
industrial production to share price index and not the other way round.
Interest rates
The basic functions of interest rates in an economy, in which individual economic agents take decisions as to
whether they should borrow, invest, save and/or consume, can be said to have three aspects, viz. interest rates as
return on financial assets serve as incentive to savers, making them defer present consumption to a future date;
interest rates being a component of cost of capital affect the demand for and allocation of loanable funds; and the
domestic interest rate in conjunction with the rate of return on foreign financial assets and goods are hedged
against inflation. These broad roles of interest rates emphasize their significance in the structure of asset prices,
stock prices being one such asset. It is the interplay between these three functions of interest rates that can be
said to determine the impact of interest rate changes on a company’s stock prices movements.
According to the Dividend Discount Model (a model used to determine the price at which a security should sell
based on the discounted value of estimated future dividend payments), required rate of return and the share price
are inversely related. Thus, returns on stocks would decrease with the increase in the interest rate. One argument
substantiating this is that an increase in interest rate will increase the opportunity cost of holding money and investors substitute holdings of fixed income interest bearing securities for shares, hence leading to falling stock
prices.
Another possible explanation is that interest rate changes can impact equity prices through two conduits: by affecting the rate at which the firm’s expected future cash flows will be capitalized, and by altering expectations
about future cash flows. In particular, an increase in interest rates leads to a decrease in expected future cash
flows and hence a decline in demand for stocks and a fall in stock prices.
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Inflation
Irving Fisher, in his treatise, The Theory of Interest (1930), predicted a positive relationship between expected inflation and nominal asset returns. Also, common wisdom indicates that stocks are hedges against inflation so that as
inflation increases, demand for stocks increases and so would the stock prices. However, the results of empirical
analysis by most researchers indicate a negative relationship between common stock returns and various measures of
expected and unexpected inflation appearing to contradict the above. These researchers have then tried to explain
the negative relation in various ways.
Based on the notion that money demand is procyclical, Fama (1981) theorizes that the inflation-stock return correlation is essentially a proxy for the negative relationship between inflation and real activity. He contends that an increase (decrease) in real activity is expected to coincide with a decrease (increase) in inflation and participants in
the stock market anticipate the changes in real activity, so that stock prices appear to move inversely with inflation.
Geske and Roll (1983) offer a “reverse causality” explanation to the inverse relation between inflation and stock returns, arguing that a reduction in real activity leads to an increase in fiscal deficits. As the Central Bank monetizes a
portion of fiscal deficits the money supply increases, which in turn boosts inflation. Stock market returns reflect the
changes in these macroeconomic variables, resulting in an inverse relationship between stock returns and inflation.
Another explanation that is offered is that high rates of inflation increase the cost of living and a shift of resources
from investments to consumption. This leads to a fall in the demand for market instruments which lead to reduction
in the volume of stock traded. Also the monetary policy responds to the increase in the rate of inflation with economic tightening policies, which in turn increases the nominal risk-free rate and hence raises the discount rate in the
valuation model and leads to decrease in stock prices.
Exchange rate
Exchange rate as an indicator of a currency movement is a monetary variable that affect prices of stock in a way
similar to the inflation variable. Depreciation of the local currency makes import expensive compared to export.
Thus, production costs of import companies increase and since all the cost cannot be passed on to the consumers
because of the competitiveness of the market, this reduces corporate earning and hence the stock prices. Even firms
whose entire operations are domestic may be affected by exchange rates, if their input and output prices are influenced by currency movements. On the other hand, for exporting companies, depreciation of the local currency increases export and hence increases in stock prices.
Money supply
Money supply in an economy is likely to influence share prices through at least three mechanisms. First, changes in
the money supply may be related to unanticipated increases in inflation and future inflation uncertainty and hence
negatively related to the share price; second, changes in the money supply may positively influence the share price
through its impact on economic activity; and finally, an increase in the money supply leads to a portfolio shift from
non-interest bearing money to financial assets including equities.
Humpe and Peter (2007) find that money supply, M1 ( a liquid measure of the money supply that contains cash and
assets that can quickly be converted to currency), does not contribute significantly to the stock price in the US. This
perhaps suggests that the various influences the money supply has on the stock price (discussed above) may ‘cancel’
each other out.
Overall importance of macroeconomic variables in explaining stock returns
It would be pertinent to see what the overall impact of certain important macroeconomic variable is on the stock
returns. Cutler, Porterba, and Summers (1989) estimate the fraction of the variation in aggregate stock returns that
can be attributed to various types of economic news. The economic variables considered by them are: real dividend
payments on value weighted NYSE portfolio; industrial production; real money supply; nominal long term interest
rate; nominal short term interest rate, monthly CPI inflation rate and stock market volatility. The results indicate
that macroeconomic news, as defined by variables above, explain only one-fifth of the movement in stock prices.
While increase in unexpected real dividend and industrial production led to increase in stock prices; inflation, unanticipated volatility and market volatility had negative and significant impact on market returns. The other variables
had less significant impact on share prices. The same result was also found by Fama (1981), whose paper concluded
that a substantial fraction of return variation cannot be explained by macroeconomic news.
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Thus, let us now look at other factors that may affect stock prices
Section II
Macroeconomic policies and stock market movements
It is believed that government financial policy announcements and macroeconomic events have large influence
on general economic activities in an economy including the stock market.
Fiscal policy
Theoretically, fiscal policy actions (changes in expenditures or taxes resulting in budget deficits or surpluses)
play a significant role in the determination of asset prices. For example, increases in taxes, with government
spending unchanged, would lower (expected) asset returns (or prices) as they discourage investors from
(further) investing in the stock market. Also, increases in government borrowing raise the (short-term) interest
rate which, in turn, lowers the discounted cash flow value from an asset (like a share) and thus signals, among
other things, a reduction in stock market activity.
From the investors’ perspective large budgetary deficits adversely impact stock and bond prices because they
increase interest rates. That is because the government, being a large borrower, soaks up large amounts of
funds that otherwise would have been available for the private sector, and thus drives up interest rates (that is,
it ‘crowds out’ private spending/investment). The increase in interest rates, in turn, will reduce business capital spending as well as consumption expenditures and ultimately undermine real economic activity. These
events will affect the financial markets by reducing asset prices and household wealth [Laopodis(_)].
Thus, this conventional analysis suggests that sustained budget deficits have severe implications on interest
rates, national saving and the external account. It also entails additional risks to the economy which include a
loss in both domestic and foreign investors’ confidence and adverse effects on the exchange rate.
Laopodis (2009) examines the extent to which fiscal policy actions affect the stock market's behavior for the US
during 1968-2005. His findings are consistent with the hypothesis that past budget deficits negatively affect current stock returns thus suggesting that the market is inefficient with respect to information about future fiscal
policy actions.
Monetary Policy
A change in one of the monetary policy instruments like the money supply or the RBI bank rate leads to changes
in market interest rates which compel investors to revalue their equity holdings. In other words, the value of an
investor’s wealth, given by the sum of the discounted future cash flows and/or dividends, is affected by an easing or tightening of monetary policy through either the discount rate or expected earnings (or both).
Thorbecke (1997) looked at the question whether monetary policy has real effects on stock returns. It measured
monetary policy by innovations in the Federal Fund’s rate and non-borrowed reserves and also by an event
study of Federal Reserve policy changes. In every case the evidence indicated that expansionary policy increases ex-post stock returns.
Bernanke and Kuttner (2003) analyzed the impact of changes in monetary policy on equity prices, with the objectives both of measuring the average reaction of the stock market and also of understanding the economic
sources of that reaction. They found that on average, a hypothetical unanticipated 25-basis-point cut in the
federal funds rate target was associated with about a one percent increase in broad stock indexes. The results
further indicated that the effects of unanticipated monetary policy actions on expected excess returns account
for the largest part of the response of stock prices.
Section III
Expectations and other developments affecting stock prices
Not only the actual economic events, but also expectations about these events seem to affect investors’ sentiments and in turn have their impact on the stock markets. There are also quite a few non-economic events,
such as those political in nature or seasonal patterns that have a bearing on stock market returns. Some of
these are examined below.
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Expectations
In one way, it can be said that stock markets movements is interplay of “expectations” which are often self
fulfilling in nature. An investor buys stocks of a company expecting that the company would perform well in
the near or long term future (based on whether he is a short term or long term investor) so that he could sell
the stock at an appropriate time to reap a profit on his investments. Suppose this feeling about the particular
stock of a company prevails across the market then everyone would want to buy the company’s stock, leading
to rising demand and hence higher prices.
Expectations may be not only about a company or an industrial sector, but also about the economy as a whole.
These could be expectations about policy stance of the government on important issue such as listing of public
sector undertakings or direction of monetary policy, viz tight or liberal policy and expectations about announcements in the annual central budgets regarding direction of government policy on financial sector reform
agenda or taxation issues having a bearing on the stock markets etc. Each of these impact sentiments of investors and their take on whether to buy or sell in the stock markets.
Seasonal patterns/calendar anomalies
The weak form Efficient Market Hypothesis (EMH) states that if the market is efficient, then the current stock
prices reflect all the information contained in its past prices and thus, follows the random walk. The presence
of seasonality or calendar anomalies in stock returns violates the weak form of market efficiency because equity prices are no longer random and can be predicted based on past pattern.
Seasonality in stock returns is said to exist if the average returns were not same in all periods. The month-ofthe-year effect would be present when returns in some months are higher than other months. In the USA and
some other countries, the year-end month (December) is the tax month. Based on this fact, a number of empirical studies have found the ‘year-end’ effect and the ‘January effect’ in stock returns consistent with the
‘tax-loss selling’ hypothesis. It is argued that investors, towards the end of the year, sell shares whose values
have declined to book losses in order to reduce their taxes. This lowers stock returns by putting a downward
pressure on the stock prices. As soon as the tax year ends, investors start buying shares and stock prices
bounce back. This causes higher returns in the beginning of the year, that is, in the month of January.
While some researchers on the Indian markets have found evidence of December effect, others upheld the taxloss-selling hypothesis in the Indian market explaining the presence of abnormal returns in April (India’s tax
year ends in March). Pandey (2002) reported the existence of seasonal effect in monthly stock returns of BSE
Sensex in India and confirmed the January effect. Kumari and Mahendra (2006) studied the day of the week
effect using data from 1979 to 1998 on BSE and NSE. They reported negative returns on Tuesday in the Indian
stock market. Moreover, they found returns on Monday were higher compared to the returns of other days in
BSE and NSE. A latest study by Chakrabathi and Sen (2007) found the November effect at the market level.
They explain this effect as happening in the month of November perhaps because during the festive season or
when the festive seasons are just over, people generally have access to more cash and/or better access to liquid cash. The optimism regarding market behaviour along with availability of liquid cash in the hands of investors to take advantage of the opportunity of market movements have probably made November the month of
significant returns in India in recent years, according to them.
Political developments
Political instability generally propels investors into a selling spree. A fragmented election result usually indicates the formation of an unstable coalition government. Investors perceive this as leading to uncertainty on
decisions for any major financial sector reform agenda or on the take of the government on fiscal or monetary
policy etc. On the other hand, if election results bring back a stable and strong government to power, both
domestic and foreign investors feel secure about investing in a stable financial sector policy regime.
Also, a political development – inside or outside the country - may have bearing on share price. Usually this
factor affects all the shares irrespective of the sector classification.
Beaulieu et al. (2003), in a study done on Canadian stock markets, defined political risk as “risks to a firm’s
profitability that are principally the results of forces external to the industry and which involve some sort of
government action or, occasionally, inaction”. These government actions which could change the business environment of firms are expropriation, policy shifts in taxation or regulation, imposition of capital and foreign
exchange controls.
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They affirmed that the impact of political risk on the volatility of stock returns could be explained by the fact
that value of a firm is equal to the present value of its expected cash flows, whereas the discount rate represents
investors’ required rate of return. If there is uncertainty, the range of realizations for expected cash flows and
discount rates should be wider and the variance of firms’ returns should grow accordingly.
In interesting paper on the Indian markets, Kakani and Ghalke (2006), using data of two market indices (BSE Sensex and NSE Nifty) for a period of more than 14 years (1991 to 2005), found that the Parliament Sessions have a
significant relation to the stock market returns. Returns are lower and market volatility is higher when Parliament
is in-session. Further evidence indicated that the average market returns (for NSE) when the Parliament is in recess is almost 10 times the average returns obtained when the Parliament is in-session. They also found that this
Parliament Session Effect was not related to two important influencers of Indian capital markets, namely, the
foreign institutional investments and the global equity markets (especially for new economy).
Integration of financial markets worldwide
Globalization has had a profound effect on financial market integration across the world financial markets, following which linkages between returns of various individual local markets have generally been observed. A number of empirical studies have documented transmission of volatility from one market to another and dynamics of
the linkages of these markets. For example, the effects of stock market crash of October 1987 and the Asian financial crisis in 1997 were widely felt in the whole world. More recently ripples of the sub-prime crisis in the US
and Europe has been felt across the financial markets of various countries.
The effect of one market largely spreads to another through foreign institutional investors (FII) who simultaneously track different market indices and continuously move funds between markets. Their confidence levels in a
particular market and strategies have now become increasingly important. If they perceive the stock markets of a
particular country as a good bet for investment, they move their investments into that economy and move out in
case of negative sentiments. The gain of one market is generally loss of another, considering that the stock of FII
funds is constant in the short term. Thus, FII investments play a key role in synthesizing markets across a region.
Also, stocks of companies are listed on more than one exchange, spread across nations so that their movements in
one markets impact their prices in other markets where they are listed and traded. In the Indian context, the
linkages between Indian markets and international stock markets can also be explained by investments through
the ADR/GDR route, whereby Indian shares are listed and traded on the US and other international stock exchanges.
Bose and Mukherjee (2005) look at the integration of the Indian stock market with many of the Asian markets and
the US stock market for the period January, 1999 to June, 2004. They find that post-Asian crisis up to mid-2004
the Indian stock market did not function in relative isolation from the rest of Asia and the US. On a daily basis the
Indian index is most highly correlated with the Singapore STI index, and is also very highly correlated with the
stock indices of Malaysia, South Korea, Taiwan and Thailand, while, the least correlation is observed with the US
S&P500 index. More importantly, during the period of the study, returns on the Indian BSE Sensex, was also seen
to exert considerable influence on stock returns in Japan and Korea, along with Taiwan and to an extent Malaysia,
though with a low probability.
Mukherjee and Mishra (2008) examined the return and volatility spillover among Indian stock market and 12 other
developed and emerging Asian countries over a period from November 1997 to April 2008. They find that the contemporaneous intraday return spillover among India and almost all the sample countries are positively significant
and bi-directional. More specifically, Hong Kong, Korea, Singapore and Thailand are found to be the four Asian
markets from where there is a significant flow of information in India. Similarly, among others, stock markets in
Pakistan and Sri Lanka are found to be strongly influenced by movements in Indian market.
In conclusion
This paper has attempted to put at one place a set of important factors that are commonly seen to drive prices in
stock markets. However, a caveat is appropriate here. There are still random forces – “the Great Unknowns” –
combined with the known factors that transmit their impact to stock prices through the laws of supply and demand. Thus, the above mentioned factors affecting stock market movements are, by no means, the only factors
that can influence stock returns.
It is interesting to note what John Maynard Keynes, British economist whose ideas have been a central influence
on modern macroeconomics, had to say about stock markets.
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In his treatise, “The General Theory”, he decried the failure of investors in stocks to consider long term values
and opined that stock market is a “casino” dominated by professionals “concerned not with what an investment
is really worth to a man who buys it “for keeps” but with what the market will value it at, under the influence of
mass psychology, three months or a year hence (The General Theory, Vol. 7, pp 154-55 ). Thus, he argued that
investors are guided by short-run speculative motives and are not interested in assessing the present value of
future cash flows from their investment. The individual investors tend to conform to the behavior of the majority
or the average. Stock markets, according to him, can be subject to positive and negative sentiment even though
no basis exists for such sentiments and hence movement of prices cannot be really understood.
These observations of Keynes, made in the 1930s seem to hold true even today when one finds that no amount of
fundamental of technical analysis is able to fully explain the movement of stock prices or determine its future
course.
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