For investors, simply investigating a company’s cash flows. sales, debt loads and other vital statistics may not be enough to understand the firm’s outlook and future. Various outside influences have a big effect on your portfolios returns - even if things are going swimmingly for your stock. Various economic indicators and forces could, and do, impact just how well your portfolio performs.
While a degree in economics isn’t necessary, understanding how these various economic measurements influence investment returns is a vital lesson for investors. Having knowledge of these basic concepts can mean the difference between big gains or a hefty portfolio loss.
Gross Domestic Product (GDP)
Commonly used as a general gauge of economic health for a nation, Gross Domestic Product. or GDP, can be a huge influence on your investment returns. Basically, GDP is the total amount of services and goods produced in a given country’s borders. This includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory.
As you would expect, this measurement of a nation’s economic health has a huge effect on stock market returns. Any significant change in GDP- up or down- usually has a significant effect on the direction of the stock market. For example, when an economy is healthy and growing, it is expected that businesses will report better earnings and growth. Obviously, these sorts of higher profits please investors of all stripes and will push them into equities. At the same time, lower GDP measurements can have the opposite effect on stock prices as businesses begin to suffer.
A prime example of this was during the recent Recession. As U.S. GDP fell and contracted, broad stock market indexes - like the SPDR 500 S&P - sank to decade lows.
Unemployment Rate/Jobs Report
Another very strong indicator that affects the stock markets is the unemployment rate. Like GDP, rate of employment illustrates the development and the strength of the economy. The Jobs Report is reported monthly by the U.S. Bureau of Labor Statistics and accounts for approximately 80% of the workers who produce the entire gross domestic product of the United States. The statistic is used to assist government policy makers and economists in determining the current state of the economy and in predicting future levels of economic activity.
Investors follow this number closely as well. The Jobs Report and unemployment rates are critical measures of an economy’s overall health. Essentially, more people with jobs equates to higher economic output, retail sales, savings and corporate profits. As such, stocks generally rise or fall with good or bad employment reports, as investors digest the potential changes in these areas.
The Consumer Price/ Produce Price Indexes
The cold hand of inflation could also be a real bear on portfolio returns. Both the Consumer Price Index (CPI) and Producer Price Index (PPI) measure the price changes of baskets of goods. The Consumer Price Index points out the average change in the price of consumer goods and services across more than 200 different categories. The data contains prices for homes, energy, food and medical items that people use on a daily basis, while the Producer Price Index (PPI) tracks the average price of over 10,000 commodities that companies will use to transform into finished goods.
For investors, periods of high consumer and producer inflation can spell the death knell for corporate profits. Higher consumer prices for basic goods can mean that there won’t be any leftover money to buy discretionary items, like Starbucks lattes. At the same time, higher PPI numbers could prevent a firm from expanding or hiring more workers, as the cost of producing goods increases. The stock market can rise or fall based on the signals these two indicators provide.
Finally, with retail sales accounting for up to 70% of the United States GDP, the monthly measure of consumer confidence and actual retail sales data is of utmost importance. Any period of extended drop-offs in retail spending - especially around seasonal highs, like Christmas - can trigger a downturn in the economy by lowering tax receipts to the government and forcing companies to reduce head counts due to decreasing profits.
Additionally, the retail sales report is one of the timeliest as it provides data that is only a few weeks old. Individual retail companies often give their own sales figures around the same time per month, and poor reports from these companies can trigger sell-offs across the entire spectrum as investors fear a stock decrease.
The Bottom Line
There are far more influences on stock holdings than just sales, earnings and debt measures; various changes in the economy can affect portfolios. as well. The smart investor knows to keep an eye on all indicators, economic and otherwise, that can signal a change in the markets. The previous measures are just some of the economic data that can be used to help shape a macroeconomic picture of the economy.
This study examines the effect of stock market on economic growth in Nigeria.Ordinary least squares regression (OLS) was employed using the data from 1989 to 2008. The results indicated that there is a positive relationship between economic growth and all the stock market development variables used. With 99 percent R-squared and 98 percent adjusted R-squared, the result showed that economic growth in Nigeria is adequately explained by the model for the period between 1989 and 2008. By implications 98 percent of the variation in the growth of economic activities is explained by the independent variables. The study affirmed positive links between the stock market and economic growth; and suggests the pursuit of policies geared towards rapid development of the stock market.
Keywords: Growth, market, stock, economic
A well developed financial system is often at the centre of any modern free enterprise economy. An efficient financial system helps to increase the standard of living and thus the society s well-being, by providing an efficient system of allocation of available resources or funds for the production of goods and services. The financial markets bring together the savers and the investors and by interaction of these two groups in an open market, the accumulated aggregate savings are channelled into viable and most desirable investment for the growth and development of the economy. In financial markets, financial assets are exchanged. A stock market is a public market for the trading of company stock and derivatives at an agreed price; these are securities listed on a stock exchange as well as those only traded privately.
Mobilization of resources for national development has long been the central focus of development economists. The stock market is an economic institution, which promotes efficiency in capital formation and allocation.
The stock market enables governments and industry to raise long-term capital for financing new projects, and expanding and modernizing industrial/commercial concerns. If capital resources are not provided to those economic areas, especially industries where demand is growing and which are capable of increasing production and productivity, the rate of expansion of the economy often suffers. A unique benefit of the stock market to corporate entities is the provision of long-term, non-debt financial capital. Through the issuance of equity securities, companies acquire perpetual capital for development. Through the provision of equity capital, the market also enables companies to avoid over-reliance on debt financing, thus improving corporate debt-to-equity ratio.
Stock market and economic growth
In recent times there was a growing concern on the role of stock market in economic growth. The stock market is in the focus of the economist and policy makers because of the perceived benefits it provides for the economy. The stock market provides the fulcrum for capital market activities and it is often cited as a barometer of business direction. An active stock market may be relied upon to measure changes in the general economic activities using the stock market index (Obadan, 1995). The stock market is viewed as a complex institution imbued with inherent mechanism through which long-term funds of the major sectors of the economy comprising households, firms, and government are mobilized, harnessed and made available to various sectors of the economy (Nyong, 1997). The development of the capital market, and apparently the stock market, provides opportunities for greater funds mobilization, improved efficiency in resource allocation and provision of relevant information for appraisal (Inanga and Emenuga, 1997).
There is a boom in the developed and emerging stock market with a substantial part of the growth accounted for by the emerging market. The reasons adduced for this are that: one, investing firms enjoy lower cost of equity when the stock market functions efficiently; two, the opportunity to trade securities and also hedge allows for relative reduction in risk; three, the ability of the market to adjust share prices almost instantaneously imposes control on the investment behavior of firms; and lastly, countries that are desirous of foreign investment are able to secure it, through the stock exchange (Demirgüç-Kunt and Levine, 1996).
Stock market contributes to economic growth through the specific services it performs either directly or indirectly. Notable among the functions of the stock market are mobilization of savings, creation of liquidity, risk diversification, improved dissemination and acquisition of information, and enhanced incentive for corporate control. Improving the efficiency and effectiveness of these functions, through prompt delivery of their services can augment the rate of economic growth.
At any stage of a nation's development, both the government and the private sectors would require long-term capital. For instance, companies would need to build new factories, expand existing ones, or buy new machinery. Government would also require funds for the provision of infrastructures. All these activities require long-term capital, which is provided by a well functioning stock market.
Stock market may also affect economic activities through the creation of liquidity. Liquid equity market makes available savings for profitable investment that requires long-term commitment of capital. Hitherto, investors are often reluctant to relinquish control of their savings for long periods. As asserted by Bencivenga, Smith and Starr (1996), without liquid capital market there would be no industrial revolution. This is because savers would be less willing to invest in large, long-term projects that characterized the early phase of industrial revolution.
Closely related to liquidity is the function of risk diversification. Stock markets can affect economic growth when they are internationally integrated. This enables greater economic risk sharing. Because high return projects also tend to be comparatively risky, stock markets that facilitate risk diversification encourages a shift to higher-return projects (Obstfeld, 1994). The resultant effect is a boost in the economy leading to growth through the shifting of societys savings to higher-return investments. Accelerated economic growth may also result to acquire information about firms. Rewards often come to an investor able to trade on information, obtained by effective monitoring of firms for profit. Thus, improved information will improve resource allocation and promote economic growth.
Demirguc-Kunt and Levine (1996) observed that there are some channels through which liquidity can deter growth: Firstly, savings rate
may be reduced, this happens when there is increasing returns on investment through income and substitution effect. As savings rate falls and with the existence of externality attached to capital accumulation, greater stock market liquidity could slow down economic growth. Secondly, reducing associated with investment may impact on savings rate, but the extent and the direction remain ambiguous. This is because it is a function of the degree of risk-averseness of economic agents. Thirdly, effective corporate governance often touted as an advantage of liquidity of stock market may be adversely affected. The ease with which equity can be disposed off may weaken investors commitment and serves as a disincentive to corporate control and vigilance on the part of investors thereby negating their role of monitoring firms performance. This often
culminates in stalling economic growth.
Edo (1995) asserts that securities investment is a veritable medium of transforming savings into economic growth and development and that a notable feature of economic development in Nigeria since independence is the expansion of the stock market thereby facilitating the trading in stock and shares.
Osinubi (1998) reported that Harry Johnson in 1990 recognized that one of the conditions of being developed pertains to having a large stock of capital per head, which must always be replaced and replenished when used up.
Where this is lacking the condition of being under developed prevails. The Structural Adjustment Programme (SAP) promoted by
the World Bank and the International Monetary Fund, embarked upon by the developing countries, according to Soyode
(1990) emphasized that self-sustained growth process requires substantial investible resources, which are readily available at the stock market.
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Published: 23rd March, 2015 Last Edited: 23rd March, 2015
This essay has been submitted by a student. This is not an example of the work written by our professional essay writers.2.1.1 Introduction
The increasing importance of stock markets in developing as well as developed countries around the world over the last few decades has moved the focus of researchers to investigate the link between stock market development and economic growth.
A stock market, as such, is a mutual organization which provides "trading" facilities for stock brokers and traders, to trade stocks and other securities. Stock exchanges also provide facilities for the issue and redemption of securities as well as other financial instruments and capital events including the payment of income and dividends. The securities traded on a stock exchange include: shares issued by companies, unit trusts, derivatives, pooled investment products and bonds.
On the other hand, economic growth relates the increase of total GDP. It is often measured as the rate of change of gross domestic product (GDP). It is that branch of one, which deals with the study of rate of change of gross domestic product, referring to the quantity of goods and services produced.2.1.2 Stock market development and economic growth
The liaison between financial growth and economic development is not a new subject in the economics literature. In 19th and 20th century, academics such as Bagehot (1873) and Schumpeter (1911) had focused on the gradual assistance of financial sector to economic growth. They observed that financial markets play a vital role in the growth process by channeling funds to the most efficient investors and by nurturing entrepreneurial innovation. Berthelemy and Varoudakis(1996), Becsi and Wang(1997), Pagano(1993) and especially Levine(1997) give excellent surveys of the functions of financial markets and how they help to improve economic development.
Levine and Zervos (1998) showed a positive and significant correlation between stock market development and long run economic growth in their study of 47 countries. However, their study relies on a cross-sectional approach with well known empirical limitations. Theoretically, the conventional literature on growth was not adequate to explore the relationship between financial markets and economic growth due to the fact that it is primarily focused on the steady-state level of capital stock per worker or productivity, but not on the rate of growth, that is, in fact, endorsed to exogenous technical progress. The growing interest of recent literature in the link between financial development and growth stems from the insights of endogenous growth models, in which growth is self-sustaining and influenced by initial conditions. In this framework, the stock market is shown not only to have level effects but also rate effects.
The "finance-led growth" hypothesis postulates the "supply-leading" relationship between financial and economic developments. It is argued that the existence of financial sector, as well-functioning financial intermediations in channeling the limited resources from surplus units to deficit units, would provide efficient allocation resources thereby leading the other economic sectors in their growth process. Indeed, a number of studies have argued that the development of financial sector has significantly promoted economic development (Schumpeter, 1912; Levine, 1997).2.1.3 FDI and economic growth
FDI is thought to be growth-enhancing mainly through the capital, technology and know-how that it brings into the recipient country. By transferring knowledge, FDI will increase the existing stock of knowledge in the host country through labour training, transfer of skills, and the transfer of new managerial and organisational practice. FDI will
also promote the use of more advanced technologies by domestic firms through capital accumulation in the domestic country (De Mello, 1997, 1999). Finally, FDI is thought to open up export markets and to promote domestic investments through the technological spillovers and the resulting productivity increase. Overall FDI is thought to be more productive than domestic investments. Indeed, as Graham and Krugman (1991) argue, domestic firms have better knowledge and access to markets, so for a multinational to enter it must have some advantages over the domestic firms. Therefore, it is likely that the multinational will have lower costs and be more productive thanks to technology and know-how.
Zhang (2001) has studied the causal relationship between FDI and economic performance in both East Asian and Latin American countries. Zhang's findings suggest that there is considerable cross-country variation and differences between East Asia and Latin America in the causal patterns of FDI-growth links. He further concluded that a key advantage created by FDI to recipient countries is technology transfer and spillover efficiency. This advantage, however, does not automatically occur, but rather depends on recipient countries' absorptive capabilities, such as a liberal trade policy, human capital development, and an export-oriented FDI policy. Investigations of the causal relationship between economic growth and FDI inflows have, therefore, a significant role in economic development. If there is a unidirectional causality from economic growth to FDI, this implies that national income growth can be treated as a catalyst in attracting inflows of FDI. Conversely, if the unidirectional causality runs from FDI to economic performance, this would strongly suggest that FDI not only stimulates the economic growth rate, but also leads to fixed capital formation and employment augmentation (Borensztein, De Gregorio, and Lee 1998; Lim and Maisom 2000; Zhang 2001). If a bi-directional causality exists between these variables, then both FDI and economic growth would have a reinforcing causal relationship.
Furthermore, the hypothesis of FDI-led economic growth is actually based on the endogenous growth model, which states that foreign investment associated with other factors--such as capital, human capital, exports, and technology transfer--have had significant effects in driving economic growth (Borensztein, De Gregorio, and Lee 1998; Lira and Maisom 2000). These growth-driving determinants might be initiated and nurtured, so as to promote economic growth through FDI. To this extent, FDI may have a positive growth impact that is similar to domestic investment, along with alleviating partly balance-of-payment deficits in the current account (Zhang 2001, p. 177). Recent studies have recommended that, via technology transfer and spillover efficiency, the inflow of FDI might be able to stimulate a country's economic performance. The spillover efficiency occurs when domestic firms are able to absorb the tangible and intangible assets of multinational corporations (MNCs) embodied in FDI.2.1.4 Stock market liquidity and growth
One way stock markets may affect economic activity is through their liquidity. Many high return projects require a long-run commitment of capital. Investors, however, are generally reluctant to relinquish control of their savings for long-periods. Without liquid markets or other financial arrangements that promote liquidity, therefore, less investment may occur in the high return projects. As shown by Levine (1991) and Bencivenga, Smith, Starr (1996), stock markets may arise to provide liquidity: savers have liquid assets - like equities - while firms have permanent use of the capital raised by issuing equities. Specifically, liquid stock markets reduce the downside risk and costs of investing in projects that do not pay off for a long time: with a liquid equity market, the initial investors do not lose access to their savings for the duration of the investment project because they can quickly, cheaply, and confidently sell their stake in the company. Thus, more liquid stock markets ease investment in long-run, potentially more profitable projects, thereby improving the allocation of capital and enhancing prospects for long term growth. Theory is unclear, however about the growth effects of greater liquidity. Bencivenga and Smith (1991) show that by reducing uncertainty, greater liquidity may reduce saving rates enough so that growth slows.
Furthermore, stock markets play an important role in allocation of capital to corporate sector that in turn stimulate real economic activity. Many countries were facing financial constraints particularly developing countries, where bank loans are restricted to some favorable groups of companies and personage investors. This limitation can also reflect constraints in credit markets (Mirakhor & Villanueva, 1990). Due to stagnant bank's return from lending to specific groups of borrowers, this return does not increase as the interest rate to borrowers rises [Stiglitz & Weiss, (1981); and Cho, (1986)]. Efficient stock markets provide guidelines as a mean to keep appropriate monetary policy through the issuance and repurchase of government securities in the liquid market, which is an important step towards financial liberalization. Similarly, well-organized and active stock
markets could modify the pattern of demand for money, and would help create liquidity that eventually enhances economic growth (Caporale et al, 2004)2.1.5 Risk diversification and growth
Risk diversification through internationally integrated stock markets is a second vehicle through which stock market development may influence economic growth. Saint-Paul (1992), Devereux and Smith (1994), and Obstfeld (1994) demonstrate that stock markets provide a vehicle for diversifying risk. These models also show that greater risk diversification can influence growth by shifting investment into higher-return projects. Intuitively, since high expected- return projects also tend to be comparatively risky, better risk diversification through internationally integrated stock markets will foster investment in higher return projects. Again, however, theory suggests circumstances when greater risk sharing slows growth. Devereux and Smith (1994) and Obstfeld (1994) show that reduced risk through internationally integrated stock markets can depress saving rates, slow growth, and reduce economic welfare.2.1.6 Information aggregation and coordination in stock market
Stock markets may also promote the acquisition of information about firms [Grossman and Stiglitz (1980), Kyle (1984), and Holmstrom and Tirole (1994)]. Specifically, in larger, more liquid markets, it will be easier for an investor who has gotten information to trade at posted prices. This will enable the investor to make money before the information becomes widely available and prices change. The ability to profit from information will stimulate investors to research and monitor firms. Better information about firms will improve resource allocation and spur economic growth. Opinions differ, however, over the importance of stock markets in stimulating information acquisition. Stiglitz (1985, 1993), for example, argues that well functioning stock markets quickly reveal information through price changes. This quick public revelation will reduce - not enhance - incentives for expending private resources to obtain information. Thus, theoretical debate still exists on the importance of stock markets in enhancing information.2.1.7 Stock market size and economic development
Demirgüç-Kunt and Maksimovic, (1996) argue that at initial stages of economic development, the expansion of stock markets increases both the opportunity for risk sharing and the flow of information in the market. These, in turn, allow firms easy and cheap access to bank loans and to increase the level of leverage. However, at the later stage as stock markets develop further, issuing equity becomes more convenient because of the declining costs and firms substitute equity for debt. Pagano et al (1998) conclude that because of trading externalities in the market and the deliberate behavior of listing companies, the size of the stock market is critical in explaining its own development. Indeed, it will increase the risk sharing opportunities through risk portfolio diversification when firm raise capital from equity financing.
In principle a well-developed stock market should increase saving and efficiently allocate capital to productive investments, which leads to an increase in the rate of economic growth. Stock markets contribute to the mobilization of domestic savings by enhancing the set of financial instruments available to savers to diversify their portfolios. In doing so, they provide an important source of investment capital at relatively low cost [Dailami and Aktin (1990)]. In a well-developed stock market share ownership provides individuals with a relatively liquid means of sharing risk when investing in promising projects. Stock markets help investors to cope with liquidity risk by allowing those who are hit by a liquidity shock to sell their shares to other investors who do not suffer from a liquidity shock. The result is that capital is not prematurely removed from firms to meet short-term liquidity needs.
North(1991) state that the founding of a new stock market will be expected to accelerate economic growth by increasing liquidity of financial assets, making global risk diversification easier for investors, promoting wiser investment decisions by saving-surplus units based on available information, forcing corporate managers to work harder for shareholders' interests, and channeling more savings to corporations. Furthermore, Bencivenga and Smith (1992) state that a new stock market also can increase economic growth by decreasing holdings of liquid assets and boosting the growth rate of physical capital, at least in the long run. In the short run, however, the equilibrium response of the capital stock to a new stock exchange can be negative because the opening of an exchange can increase households' wealth and raise their contemporaneous consumption enough to temporarily lower the growth rate of capital.
From a monetary growth prospective a well-developed stock market provides a means for the exercise of monetary policy through the issue and repurchase of government securities in a liquid market. A modern financial system promotes investment by identifying and funding good business opportunities, mobilizes savings, monitors the performance of managers, enables the trading, hedging, and diversification of risk, and facilitates the exchange of goods and services. These functions result in a more efficient allocation of resources, in a more rapid accumulation of physical and human capital, and in faster technological progress, which in turn feed economic growth [Creane, and Al. (2004)].
In addition, the "feedback" hypothesis suggests a two-way causal relationship between financial development and economic performance. In this hypothesis, it is asserted that a country with a well-developed financial system could promote high economic expansion through technological changes, product and services innovation (Schumpeter, 1912). This in turn, will create high demand on the financial arrangements and services (Levine, 1997). As the banking institutions effectively response to these demands, then these changes will stimulate a higher economic performance. Therefore, both financial development and economic growth are positively interdependent and their relationship could lead to feedback causality. The work of Luintel and Khan (1999), among others, is supportive of this view.2.1.8 Inflation and economic development
The negative effects of inflation have been studied in the context of the models of economic growth, in which the continuous increase of per capita income is the outcome of capital accumulation along with technological progress. The uncertainty associated to a high and volatile unanticipated inflation has been found to be one of the main determinants of the rate of capital and investment [Bruno (1993 ), Pindyck and Solimano (1993)]. Besides, inflation undermines the confidence of domestic and foreign investors about the future course of monetary policy. Inflation also affects the accumulation of other determinants of growth such as human capital or investment in research and development and thus slows down economic growth.
But over and above these effects, inflation also worsens the long run macroeconomic performance of the market by reducing total factor productivity. A high level of inflation induces a frequent change in prices which may be costly for firms and reduces the optimal level of cash holdings by consumers. Several authors have found a negative correlation between growth and inflation. Kormendi and Meguire (1985) estimate a growth equation with cross-section data and find that the effect of inflation on growth is negative, although it loses explanatory powers when the rate of investment is included in the regression. This would indicate that the effect of inflation mainly manifests itself in the reduction in investment and not in the productivity of capital.
More recently, the study of the long- run influence of inflation has progressed within the framework of convergence equations developed by Barro and Sala- I-Martin (1991). Fischer (1994, 1993) reports a significant influence of several short term macroeconomic indicators and in particular inflation, on the growth rate.2.1.9 No relationship between stock market development and growth
However traditional growth theorists believed that there is no correlation between stock market development and economic growth because of the presence of level effect not the rate effect. Similarly, Singh (1997) contended that stock markets are not necessary institutions for achieving high levels of economic development. Many viewed stock market as a agent that harm economic development due to their susceptibility to market failure, which is often manifest in the volatile nature of stock markets in many developing countries (Singh, 1997; Singh & Weis, 1999). So, the traditional assessment model of 'stock prices' and the 'wealth effect' provide hypothetical explanation for stock prices to be proceeded as an indicator of output (Comincioli, 1996). According to wealth effect, however, changes in stock prices cause the variation in the real economy.
In a recent survey of development economics, Nicholas Stern (1989) does not mention the role of the financial system in economic growth. Furthermore, at the end of Professor Stern's review, he lists various issues that he did not have sufficient space to cover. Finance is not even included in the list of omitted topics. Similarly, a recent collection of essays by the 'pioneers of development economics, including three Nobel Laureates, does not describe the role of the financial system in economic growth (Meir and Seers (1984)). Clearly, according to these economists, the financial system plays an inconsequential role in economic development. Furthermore, the most recent Nobel Prize winner, Robert Lucas (1988), argues that economists frequently exaggerate the role of financial factors in
economic development. Moreover, Joan Robinson (1952) argues that the financial system does not spur economic growth; financial development simply responds to developments in the real sector. Thus, many influential economists give a very minor, if any, role to the financial system in economic growth.
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