Economic Forces and Stock Market

Chen, Nai-Fu, Roll, Richard and Stephen A. Ross. “Economic Forces and the Stock Market.” The Journal of Business 59, 3 (1986): pp.383-403. Chen, Roll and Ross (1986) were among the earliest researchers to identify and test economics factors that should affect stock returns either through future cash flows or through the discount rate. By analyzing factors such as inflation, the term structure of interest rates, industrial production etc. and discovered them to be important in explaining stock returns. Simply stated, Chen et al. strove to discover, the relation of stock price and macroeconomic variables.

In 1986 Chen et al. observed and experimented the influence of economic state variables on the stock prices. By experimenting with the US economic data they established that the economic state variables work as discount rate and affect the future dividends, which in turn influence the stock prices. APT factors of Chen, et al. include: Growth in Industrial Production (MP), Changes in expected inflation (DEI), Unexpected Inflation (UI), Unexpected changes in risk premiums (URP), Unexpected changes in term structure slope (UTS).

The macroeconomic variables are the foundation of APT model. According to the findings of the paper, effect of these variables on the equity return is as follow:
Inflation: Inflation influences the Discount rate and future cash flows. Chen, Roll and Ross (1986) showed negative relation between inflation and stock market.
Risk Premium: In order to know the markets reaction to risk, return on safe bonds and risky bonds are used.

The term structure of interest rates: the relation of stock prices with long-term interest rate is negative. The short-term interest rate may or may not have negative influence on stock prices. Stock returns were more negative in periods when industrial production fell, and the default spread, unanticipated inflation occurred and the actual rate of return witnessed an increase. Stocks did considerably better in periods when the yield curve was more upward sloping, long term rates were elevated than short-term rates.

Persistence in Mutual Fund Performance
Carhart, Mark M. “On Persistence in Mutual Fund Performance.” The Journal of Finance 52, 1 (1997): pp.57-82.

Carhart observed the persistence in mutual fund performance by using a sample of equity fund. He took a total of 1,892 funds as a sample of equity from 1963-1993. He divided the sample in three categories, aggressive growth, long-term growth, and growth-and income. Carhart utilized Capital Asset Pricing Model (CAPM) and Four Factor Model (FFM) for performance measurement.

Carhart explains that Funds portfolios are ranked on lagged one-year returns to estimate the performance. The fund portfolios are equally weighted; when the fund disappears, the rate is readjusted. With the CAMP model on the decile portfolios the post-formation monthly excess returns decreases monotonically in rank and shows annualized spread of 8 percent while in four-factor model, size and momentum accounts for the spread among portfolios. It was found that expense ratios, portfolio turnover, and load fees are negatively related to performance. The performance is reduced one-for-one by expense rations and turnover reduces performance about 95 basis points for every transaction. The load fund consistently and substantially underperforms no-load funds. In addition, the funds with high past alpha performs high alphas and higher expected returns. The funds on top-decile earn back investment cost but the bottom-decile funds underperforms about twice there investment cost.
At last, Carhart suggests mutual fund investors that funds, which constantly performed poor, are not be consider, the funds which show high return last year, will show expected returns next year higher than average and performance have a negative impact by investment cost, transaction cost and load fees.

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