Economics and Finance sgx
Dissertation: Relationships between Stock Returns and Macroeconomic Indicators – Evidences from Singapore (Part 1/5)

CHAPTER I: INTRODUCTION

1.0 Research Background

To predict the direction of stock market has been the interests of many people as it is reasonable to believe that people that have such ability will become rich very soon. However, the task to predict stock market and its directions can be complex and hard. Not only to able to predict the directions of stock market is hard, there are also different perspectives on how to predict the stock market returns or direction in the future. For examples, generally speaking, two different and often contradicting school of thought in predicting stock market direction can be separated into the technical analysis and fundamental analysis. To explain, technical analysis is about predicting the future stock market direction using charts and historical prices. In contrast, fundamental analysis is about predicting the future stock market returns through understanding on the economic or company fundamentals.

Not only is the ideas and methods used by the practitioners or scholars in predicting future stock market returns is controversial and contradictory; often, there is no certainty that any school of thought able to do better than the other. Besides, researchers and observers tend to have different opinions that certain tools or philosophies are useful in predicting stock market returns, while the other researchers simply think that the particular tools or methods are useless. In such context, the usage of economic indicators to predict future stock returns is a highly controversial topic. For example, there are many books talking about opportunities to be reaped through understanding and applications of leading economic indicators in predicting stock returns. For example, Baumohl (2005) had published a book named ‘The secret of economic indicators: hidden clues to future economic trends and investment opportunities’ to discuss the usefulness of economic indicators towards investment decision making process. According to Baumohl (2005), economic indicators are useful to provide a snapshot understanding on the true picture of economy of a nation, and thus, will able to assist investors to form valid and sensible expectations on the future stock returns in the near terms. Indeed, a total of then influential economic indicators towards stock returns are published. The ten most influential economic indicators, arranged in sequence of importance to future stock returns, are: employment situation report (payroll survey), ISM report (manufacturing), weekly claims for unemployment insurance, consumer prices, producer prices, retail sales, consumer confidence and sentiment surveys, advance reports and durable goods, industrial production and lastly, changes in gross domestic products (GDP). Then, in a similar manner, Tainer (2006) had published a book, namely ‘Using economic indicators to improve investment analysis’ to guide investors on how to utilize the hidden messages delivered by economic indicators. In fact, these are not just two of the investment books arguing that economic indicators are useful in predicting stock returns. Other investment related books emphasizing the usage of economic indicators to predict stock return include the follow: Yamarone (2007), Moss (2007), Enders (2004), Zweig (1997), Bodie, Kane, & Marcus (2007), and etc.

In contrast, there are also many successful practitioners, and indeed, famous investors urging investors to ignore forecasts from economists in predicting stock returns. These famous investors think that not only the predictions are largely inaccurate, but relying on these predictions can be detrimental to the wealth of the investors. For example, Warren Buffer, the legendary investors around the world, has been urging investors not to trust economic predictions, as the economic prediction can hardly time the market accurately. To be exact, according to Warren Buffett, in terms of market timing, ‘there are two types of people, firstly, those who know that they don’t know, and secondly, those who don’t know that they don’t know’ (Buffett & Clark, 2006; Hagstrom, 2005). Then, according to the legendary fund manager, namely Peter Lynch, it is argued that most investors would do better if they simply just ignore the economic prediction of so called experts. It is pointed out that many of the time, economic predictions are simply inaccurate. Then, the best time to buy stock is after the crisis, when the economic outlook is terribly pessimistic and scary (Lynch, 1993; Lynch, 2000). Indeed, another famous and highly respected investor, John Templeton, is famous for his bargaining skills. According to the Templeton, the best time to buy stocks is when the economy outlook and projection are of the bleakest, at the point of maximum pessimism (Templeton & Phillips, 2008). This is somewhat contradictory to the arguments presented by economists – as it is the conventional wisdom to sell stocks when the economic outlook is gloomy, as when economic turn south, stock prices will plummeted significantly.

As such, the contradictory arguments from economists and some of the successful practitioners are something to be understood and investigated seriously. For any serious and truth-seeking investors, it is the investor imperative to verify the validity of the arguments from both parties. Indeed, without understandings if economic indicators are truly useful for stock returns predictions, it is hard for investors to make rational judgment to guide their stock buying behaviors. As such, in this study, the relationships of macroeconomic indicators to stock returns will be studied.

1.1 Research Rationales

As discussed above, there are significant and confusing contradictory arguments if economic indicators can be used to forecast stock returns or to guide investors in their investment decision making process. Hence, considering the contradictory opinions about the usefulness or relevancy of economic indicators in predicting the stock market directions in the future, a research on the relationships between economic indicators to the stock market index is necessary. It is important to at least investigate if any statistical significant relationships between stock market returns to economic indicators, to produce empirical evidences if economic indicators are indeed useful (or not) in predicting stock market return. This study is critically important for any diligent and serious investors, as though application of scientific methods (through quantitative methods), the relationships between stock returns to several economic indicators can be analyzed and investigated in a more objective manner. Through the findings from such kind of studies conducted in this dissertation, investors may be able to reject the false ideas or assertion by either one of the two contradicting parties confidently. Specifically, if not significant statistical relationships are found between macroeconomic indicators to stock returns, investors can then ignore the news related to macroeconomic and conclude the assertion of the proponents that macroeconomic indicators are useful in predicting stock returns as absurd ignorance.

It is acknowledged that the studies of macroeconomic indicators relationships to stock returns are common in the finance and investment related literature in the past few decades. For example, as to be further discussed in the literature review section in the following chapter, among such studies includes one performed by Huang and Kracaw (1984), Hasbrouk (1984), Pearce & Roley (1985), Chen, Roll & Ross (1986), Kim & Wu (1987), Bodurtha, Cho and Senbet (1989), Fama (1990), Chen (1991), McGowan & Dobson (1993) and many others. However, it is observed that most of the studied conducted are concentrated on countries such as the United States, the United Kingdom, or other more developed countries. Although in the recent years, increasingly studies have been conducted to study the macroeconomic factors relationships to stock returns in the emerging countries, voluminous of researches are indeed focusing on studying more powerful and influential emerging countries such as China and India. For instances, studies or literature related to macroeconomics forces and stock returns in China has been conducted by many researchers, which include: He & Ng (1994), Drew, Naughton, & Veeraraghavan (2003), Drew, Naughton, & Veeraragavan (2005) and Mei (1993). The studies investigating the relationships between smaller countries, such as for the case of Singapore, are relatively unpopular. Indeed, according to the knowledge of the authors, there are no up-to-date studies on relationships of macroeconomic indicators to stock returns in Singapore in the recent years. This is pretty surprising, considering Singapore as one of the famous countries around the world, for its fast economic growth, despite it being a small island in South East Asia. As such, this study will be able to cover the gap on the existing literature in the context of relationships between macroeconomic indicators to stock returns in Singapore.

1.2 Research Objectives

From the preliminary discussion presented above, several research questions can be generated. Firstly, it is about whether which party is saying the truth. There are people asserting that macroeconomic indicators can be used to predict stock returns, while they are also opposition commenting that macroeconomic indicators cannot be used to predict stock returns. Indeed, seemingly honest and reputable successful investors, such as Warren Buffett, Peter Lynch and John Templeton has been arguing that investors may be benefited significantly if they ignore all of the macroeconomic news available in the marketplace. In contrast, these legendary investors keep asserting that investors should buy when the situation seem worst. As such, another important questions to answer is that why, if so many legendary successful and wealthy investors are arguing that macroeconomic indicators, news and prediction should be ignored, there are many investment related books preaching investors to track the economic indicators for better accuracy in prediction of stock returns. From these research questions, several research objectives can be formulated as follow.

 

Research Objective #1: To reject the false assertion on usefulness or practicality of macroeconomic indicators for prediction of stock returns.

 

Research Objective #2: To understand if there are statistical significant relationships between economic indicators and stock market returns (i.e., directions) in Singapore Stock Exchange. For this, the Pearson correlation coefficients between the different macroeconomic indicators to stock returns in Singapore will be computed and investigated.

 

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