Impact of Stock Market Volatility (Part-I)
-----Dr.Debesh Bhowmik
The conventional finance theory
suggests that the stock market (excess) return, being a forward-looking
variable that incorporates expectation about future cash flows and discount
factors, contains useful information about investment and future output growth.
Empirical literature provides substantial evidence in favour of this
proposition .It is also seen from a number of recent studies that increased
stock market volatility depresses economic activity and output . Empirical
results presented by Campbell et al. (2001), in particular, are very important
in this regard. They show that each of stock market volatility and excess
return, when considered singly (i.e. when only one of these variables - either
return or volatility - is considered) after controlling the lag dependent variable,
is significant in explaining future output growth. But, when both volatility
and excess return are considered as regressors (in addition to lag dependent
values), volatility drives out return in predicting future output growth. As
per the existing literature, stock market volatility may affects output growth
through several possible channels, such as, (i) its link with market
uncertainty and hence economic activity, (ii) association between market
volatility and structural change (which consumes resources) in the economy,
(iii) link of volatility with cost-of-capital to corporate sector through
expected return. It is, however, not clear to justify why volatility drives out
return in predicting output growth as observed by Campbell et al.(2001). Guo
(2002) has discussed major arguments put forward by the proponents of volatility
effects on output and has reconciled the evidence provided by Campbell et al. (2001)
with earlier empirical evidence on predictive power of the stock market returns
and finance theory. Based on a small model he argues that volatility may
influence output growth (or may drives out returns in predicting output) in
some specifications possibly because of its influence on cost of capital
through its link with expected return.
But if cost of capital is the
main channel through which volatility affects output then returns should play
more important role in forecasting output growth than volatility does. He also
provides empirical results to support this hypothesis. He derives relevant results
for three different time periods; one longer than (but covering), one identical
with, and another adding more recent years but shorter in length than the
Campbell et al. (2001) sample period. Interestingly, using Campbell et al.
(2001) sample, he finds that
the volatility drives out returns
in predicting output growth because of the positive relation between excess
returns and past volatility; if this relation is controlled for, excess returns
show up significantly in the forecasting equation. In the liberalisation era,
volatility in Indian financial markets is believed to have
increased/changed and thus there
is a need to assess the impact of financial market volatility on output growth.
With this background, this article presents some preliminary observations
regarding link between stock market volatility/excess return and future output
growth.
Some recent studies have shown
that elevated stock market volatility depresses output. As per the conventional
finance theory, however, it is the stock market (excess) returns that should
have impact on future output growth. Currently, the issue is important in
India, as there has been a perception that the volatility in Indian financial
markets has increased/changed during the liberalisation era. Empirical results
show that stock market volatility is strongly influenced by its own past values
– pointing to the presence of significant volatility-feedback effects in the
stock market. The volatility is also quite strongly related (at least
contemporaneously) to excess return in recent years. However, roles of stock
market return and volatility in predicting future output growth are not clear.
Because, coefficients of lags of both these variables in the equation for
future output growth are generally insignificant and in some cases have wrong
signs, though during April 1997 to December 2002 only the volatility shows
quite strong influence on output growth. Thus, there is a need to undertake
further in-depth research for understanding the relationship between stock market
return/volatility and future output growth in the context of Indian economy.
Thus, stock market uncertainty
can have large effects despite the fact that households’ direct stock market
participation is rather limited. Similarly, if stock market volatility can be
viewed as an indication of how uncertain firms regard future developments, it
can have a large effect on investment even if only a small fraction of firms in
an economy
are subject to financing
conditions determined by stock price movements. We provide empirical evidence
on the relationship between stock market volatility and the business cycle and
review the existing literature.
The empirical observation that
stock market volatility tends to be higher during recessions points toward a
negative relationship between stock market volatility and output. Fig-1 shows a
scatter plot of U.S. quarterly percentage growth of real GDP against implied U.S.
stock market volatility together with a fitted regression line.
The negative relationship between
volatility and output growth is clearly visible. Scatter plots using historical
volatility or GJR-based volatility instead of implied volatility show a similar
negative relationship.
Although the empirical evidence
presentedin the previous section indicates a close relationship between stock market
volatility and economic fluctuations, the evidence is only suggestive.However,
several papers document similar linkages using more detailed empirical
approaches. The empirical study of Romer (1990) deals primarily with the onset of
the Great Depression. However, Romer also presents estimates of the relationship
between stock market volatility and consumption in the U.S.A.
Table-1: U.S.
Ouarterly Stock Market Volatility
in Periods of
Expansion and Recession
Fig-1:U.S. Stock
Market Volatility and GDP Growth
for the post-war period. Using
annual U.S. data ranging from 1949 to 1986, she concludes that a doubling of
stock market volatility reduces durable consumer
goods output by about 6%, whereas
the effect on nondurables is essentially 0. This ordering of the magnitudes of
the effects is consistent with the idea that stock market volatility is closely
related to uncertainty about future real economic activity. This is
because non reversibility gives
rise to a lock-in effect that is particularly pronounced
during periods of high
uncertainty.
Consider for instance a consumer deciding
to buy a durable consumption good. Given the durable nature of the good and the
uncertainty about future income, it may turn out that the good is either too modest
or too luxurious with respect to future income. However, if the consumer waits until
uncertainty is resolved, it may be easier to choose an appropriate good.Thus,
by postponing the purchase of the good, the lock-in effect can be avoided and
the benefit of doing so increases with the level of uncertainty. It follows
that decisions that are irreversible to a larger extent are postponed, resulting
in particularly pronounced reactions of durable consumption expenditures and
investment expenditures to increasing stock market volatility.
Since investment decisions are
presumably the least reversible, one would expect that stock market volatility
has the largest effect on investment spending, followed by durable consumption and
nondurable consumption. Note that if households substitute away from durable
consumption goods into nondurable consumption goods because of higher
uncertainty, then nondurable consumption may even rise during periods of high
stock market volatility. Raunig and Scharler (2010) evaluate the uncertainty
hypothesis by estimating the influence of stock market volatility on durable
consumption growth, nondurable consumption growth and investment growth. Their analysis
is based on quarterly time series data for the U.S.A. Based on a number of different
estimates of time-varying stock market volatility, Raunig and Scharler (2010) find
that stock market volatility exerts an economically and statistically
significant effect on aggregate demand.
Moreover, they find that the
adverse effect of stock market volatility on aggregate
demand depends on the extent to which
decisions are reversible. Based on their richest specification (Table 2), they
find that an increase in volatility by one standard deviation reduces the quarterly
growth of durable consumption by around –0.70 percentage points, whereas the
effect on the growth of nondurable consumption is only –0.14 percentage points.
Investment growth responds with a lag of one quarter and declines by 1.12
percentage points.
Table-2:Effect
of an Increase in Stock MarketVolatility by one Standard Deviation
on U.S.
Consumption and Investment Growth
Hence, the decline in the growth
of durable consumption and investment is larger during periods of increased
volatility than the decline in the growth of nondurable consumption, which is
again fully consistent with the predictions of the uncertainty hypothesis. In
addition to being statistically significant, the estimated effects are also
substantial in an economic sense. Stock market returns, in contrast to volatility,
have a quantitatively smaller and often statistically insignificant influence on
consumption and investment.
This result is consistent with Lettau
and Ludvigson (2004), who also find that returns exert only a limited influence
on consumption. The reason is that although permanent shocks to stock prices
have a strong effect on consumption, most fluctuations in prices are transitory
and exert only small effects on consumption.
Alexopoulos and Cohen (2009) identify
uncertainty shocks using vector autoregressive methods. To measure uncertainty,
they use stock market volatility measures, as in Raunig and Scharler (2010) and
Choudhry (2003), and also an index based on the number of New York Times’
articles on economic uncertainty. They find that uncertainty shocks play an
important role for the business cycle. In particular, uncertainty measured by
the New York Times’ index accounts for up to 25% of the short-run variation in
employment
and output. Choudhry (2003)
analyzes the influence of stock market volatility on GDP and the components of
GDP using an error-correction framework. Under the assumption that volatility
follows a non -stationary stochastic process, he estimates the short-run and
long-run dynamics of GDP components using an error-correction framework. His
results confirm that stock market volatility has adverse effects on consumption
and investment.
A different, but closely related,
issue is analyzed in Jansen and Nahius (2003) They analyze how stock market
fluctuations influence consumer sentiment in a sample of eleven countries. They
find that in the vast majority of countries under consideration, consumer
sentiment and stock returns are positively related. They also find that
causality runs from stock returns to consumer sentiment rather than vice versa.
Moreover, they conclude that the correlation between stock returns and consumer
sentiment mirrors expectations about future economic conditions. Therefore, the
evidence presented in their paper also provides some backing for the uncertainty
hypothesis, in the sense that stock market fluctuations give rise to
uncertainty about future economic conditions.
Note that although the
uncertainty hypothesis suggests that causality runs from stock market
volatility to the business cycle, this need not necessarily be the case.
Although the early literature on the determinants of stock market volatility finds
only weak linkages between stock market volatility and macroeconomic variables,
recent empirical research (e.g. Engle et al., 2008; Diebold and Yilmaz, 2010)
establishes important linkages between macroeconomic fundamentals and stock
market volatility. In particular, Arnold and Vrugt (2008) find a strong link
between macroeconomic uncertainty and stock market volatility using survey data
from the Survey of Professional Forecasters maintained by the Federal Reserve
Bank of Philadelphia. The authors find that rising uncertainty about future
macroeconomic developments increases stock market volatility. Thus, taken
together with the evidence presented above, it appears that causality between
macroeconomic outcomes and stock market volatility is bidirectional.
