Investors consider the profit of a firm as the main driver of the value of an individual stock. The other variables are seen as indicators or catalysts bringing future levels of profit into consideration. Profit (return) in stock market is viewed as economic profit (dividend plus capital gains) rather than accounting profit. Accounting profit can be described as the difference between total revenue and total cost.
Profit = Total Revenue – Total Cost (5.1)
A portfolio (or market as a whole) is a combination of individual stocks. Certain macroeconomic variables should affect the aggregate profit of the stock market. What affects individual stocks also affects the stock market return as a whole through the effect on total revenue or total cost.
In chapter 4, sufficient evidence of the relationships between the stock market and variables of other macroeconomic markets, was set out. Seven macroeconomic variables were identified as the likely sources of systematic risk. Moreover, the effect of the selected variables on the profitability of the stock market was analyzed in this chapter. Selected variables, except real GDP, represent the prices from major macroeconomic markets because
demand and supply is reflected in prices, and these variables are proxies for the underlying risk factors for the profitability of individual firms (affecting the numenator or denominator of the valuation model) and therefore, the stock market return as a whole. Table 5.1 shows the selected macroeconomic variables and expected signs (positive or negative) of the relationship with the stock market index (ASX200).
Table 5.1. Selected macroeconomic factors and the expected sign of the relationship
RGDP Real GDP +
CPI Consumer price index +
10YB Yield on 10 year bond -
LCI Labour cost index -
CP Commodity price index +
TWI Trade weighted index +
NYSE US NYSE Index +
The total revenue of a firm is affected by: real GDP, inflation, commodity prices, exchange rate and return on foreign markets, while total cost is affected by: interest rates, wage rate, commodity prices and exchange rate. Therefore, stock market return should have exposure to these variables.
GDP was included in the proposed equation as a measure of the overall economic activity affecting the stock market return, through the effect on firms‟ cash flow (numerator effect). Real GDP is the most comprehensive measure of the overall performance of the economic activity. It is expected that there will be a positive relationship between real GDP and the stock market return. The positive relationship is attributed to changes in the numerator
effect in a valuation model. Higher real GDP means higher demand for goods and services, therefore higher revenue for the firm and higher stock prices1.
It is expected that the inflation rate and stock market return to be correlated in the same direction. There is a general expectation that the relationship between stock return and inflation (actual and expected) is positive because higher inflation means higher product prices for the firms and therefore higher revenue. Another point of view is that stock prices will be a hedge against inflation because they are claims on real assets2.
The interest rate is related to the stock market return in several ways. Firstly, interest bearing assets such as bonds and stocks are substitutes, in terms of portfolio investment. Portfolio theory suggests that an increase in interest rates leads to a portfolio shift from non- interest bearing money to interest bearing financial assets, such as bonds. Higher interest rates mean lower stock prices as a result of the substitution effect. Secondly, interest is a cost factor of the firms and it affects the cash flow of the firms (numerator effect). Higher interest rates mean lower profit. Finally, the interest rate is the discount factor (denominator effect). Cash flow over time is discounted using interest rates. Higher interest rates mean a lower net present value of the investment3.
About 55 per cent of the total cost for firms in Australia is comprised of labour costs. It is expected that there will be a negative relationship between stock return and labour costs because higher labour costs mean lower profit for the firm. Labour costs affect the stock return through the numerator effect4.
Commodity prices are included to provide for the possible effects on the stock market through both the numerator and the denominator effect. The inclusion of this variable is meaningful in the Australian context, given the importance of commodities to the Australian
1 See section 4.2 2 See section 4.3 3
economy. An increase in commodity prices will lead to an increase in the cost of production for some firms, while increasing revenue of commodity-producing firms. However, the expected net effect of commodity prices on the stock market return as a whole is indeterminate.5
It is expected that the firm value would be related to the exchange rate because at least one of the input and output prices, or demand for its products, can be affected by the exchange rate, and hence, the value of the firm. Some firms will be negatively related to the exchange rate and others will be positively related to it and some not at all. Thus, it is expected that, as a priori, exchange rates are unlikely to yield a significant coefficient6.
The relationship between the Australian and the US stock market has been significant from several aspects. Firstly, the movement in the US market is a good indicator of global economic growth which in turn affects Australian stocks. This is because the US economy is about 25 per cent of the world economy and US firms have worldwide interest. Secondly, some Australian companies‟ earnings depend on the US economy. Thirdly, Australia and the US follow a similar business cycle. For those reasons it is expected that there will be a positive significant relationship between Australian and the US stock market7.