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What Drives Australian Stock Market? A Graphical Analysis.

David Solomon Hadi - Chief Strategist Financial Services Rock Star Consulting Group www.rockstarconsultinggroup.com

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Summary of Findings In the preliminary research work: 1. It has been found that Money Supply (M1), Price Level, Gross Operating Surplus of Firms and Price of Financial Assets influence Stock Index after, on average, 4 quarters. 2. It has been found that Expected Prices, Gross Domestic Product, Disposable Saving (part of disposable income) do not cause any changes in Stock Market. This is preliminary research. Caution is to be taken before accepting the validity of results. Introduction This report is a novel attempt to present a preliminary set of findings about causal relation of Australian Stock Exchange and Economic Conditions using a graphical analysis. Graphical Analysis is useful because it enables the readers to see and understand the market in a visual way yet it is based on sophisticated mathematics and econometrics. The graphs are obtained via method of Impulse Responses of Vector Auto Regressions. The graphs represent a highly possible causal relation. In the following lines a summary of data used, brief description of how to read the graphs is presented, followed by graphs them self, later very simple summary of underlying technical work is given. Using Australias Reserves Bank Data Base and Yahoo Finance, a list of variables is collected. These included; Stock Index ,Expected Prices, target cash rate, money supply (M1), gross domestic product, a component of gross domestic product called gross operating surplus, disposable saving (part of disposable income), price (general) and price of finance goods is used. The reason of operating surplus is that it indicates the working of industries (non finance and non-farm). The reason of traded goods price is that it indicates the prices of real goods (opposed to services) in market. The data was quarterly beginning from December 1998 and ending on September 2013. The results for test of being a potential cause of stock market activity for each of the variables is given in the graphs below. To read the graph one should think of a sudden change in variable (named above the graph as shock). This sudden change is one standard deviation from its

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average value. This sudden change then leads to deviation from mean in the stock market (which is measured on Vertical Y axis) over time (which is measured on the horizontal X axis). The grey shade is minimum to maximum possible reaction. The red line is average reaction. Only those graphs where cause was found are presented, to save space. One should note that there is very rough movement in Stock market that means stock market shows small and fast changes. To avoid this, a filter is used. This filter is called Hodrick Prescott. It finds a path of development of price between two points in time depending on how much one wants to avoid these small quick changes. (the details are in last section).

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The Graphical Presentation

response of stock_index to a shock in money_supply, with bootstrap confidence interval 0.05 0.04 0.03 0.02 0.01 0 -0.01 -0.02 -0.03 -0.04 -0.05 -0.06 1 2 3 4 5 periods 6 7 8 9 10 90 percent confidence band point estimate

A sudden change in money supply as measured by M1 leads to more money in market. This extra money is used by people to buy stocks. This increases the demand of stocks in market and therefore leads to rise in stock market index. This rise peaks after 3 quarters. Then it shows a reversal i.e. index starts falling , after 8 quarters. Data scarcity prohibits full path development beyond 10 quarters. The reason of two opposite reaction is made clear by fact that money supply increase leads to price rise. Price rise shows negative impact on stock market which is presented on next page

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response of stock_index to a shock in price_level, with bootstrap confidence interval 0.02 90 percent confidence band point estimate

0.01

-0.01

-0.02

-0.03

-0.04

-0.05

-0.06 1 2 3 4 5 periods 6 7 8 9 10

A sudden change in price level (inflation) leads to less money in pockets of people. This lesser money means people buy less stocks. This lowers the demand of stocks in market and therefore leads to fall in stock market index. This fall is maximum after 4 quarters. Then it gradually disappears after 6 quarters.

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response of stock_index to a shock in operat_surplus, with bootstrap confidence interval 0.08 90 percent confidence band point estimate

0.06

0.04

0.02

-0.02

-0.04

-0.06 1 2 3 4 5 periods 6 7 8 9 10

A sudden change in surplus (gross operating surplus) of firms in Australia leads to higher expectation of dividend return by people. This motivates people to buy stocks. This increases the demand of stocks in market and therefore leads to rise in stock market index. This rise peaks between 3and 4 quarters. Then the effect of this change in surplus disappears.

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response of stock_index to a shock in finance_price, with bootstrap confidence interval 0.1 90 percent confidence band point estimate

0.08

0.06

0.04

0.02

-0.02

-0.04

-0.06

-0.08

-0.1 1 2 3 4 5 periods 6 7 8 9 10

A sudden change in price of finance goods leads to less return on that good. A costly good at constant interest earning means less net return. This discourages people to buy stocks. This lowers the demand of stocks in market and therefore leads to fall in stock market index. This fall is very minute and is maximum after 3 quarters. Then it quickly disappears. The Summary Of Technical Work The data was noisy. Hodrick Prescott filer is used to avoid noise. The value of penalty of noise is 100. This is less than recommended by Hodrick and Prescott, however. Hodrick Prescott minimizes the variance of the original series y around the smoothed series , and subject this to a penalty based on the variance of . Mathematically:

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Min:

( yt t )2 [(t 1 t ) (t t 1 )]2
t 1 t 2

T 1

As the rise the filtered time series become smoother and finally it may be reduced to one straight line . Hodrick and Prescott (who introduced it) claim that should be 100 for data from year to year changes and 14400 for monthly changes. But then again this is in discretion of researcher. The stationarity test for second differences of transformed time was successful. The details are below: Test conducted: Augmented Dickey Fuller Generalized Least Square Test: Hypothesis: Time Series is non stationary. Critical P value for hypothesis rejection: 0.05 Variable Expected Prices Cash rate Money Supply Gross domestic product Disposable saving Price level P value 0.001571 0.0001 0.01411 0.004428 0.02726 0.02062

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Finance Price Operating Surplus Stock Index

0.01228 0.01216 0.01824

The Causation can be established as follows: Identification of a cause from X to Y (any two variables), given that there may be a host of other unobserved factors causing Y, requires a change in X such that source of change has nothing to do with Y and is related to X only (very strictly). In a Vector Auto Regression between X and Y, the error terms are considered as shock or sudden changes. Error terms are values that the model fail to explain. These are effects of variables not added in model. If these errors are uncorrelated with X and Y, the requirement mentioned above is satisfied. This would be understood with following example: If beer is neither stored nor exported (that is all production is consumed), it would be easy to identify if the beer is cause of crime or not by using the past year yield of main ingredients of beer. These past yields would effects production of beer which now equals consumption. These yields them self are not cause of crime (more barley more crime? NO). If the forecasted values of beer production forecasts crime, cause would be identified. In the Vector Auto Regression the past year yields are all in error terms. In the research two variables were considered in a Vector Auto Regression at a time. The table below shows correlation of errors in equation of given variables in Vector Auto Regression with Stock Index. The results are very weak (close to 0). They strongly support the requirement mentioned above: Errors of Equation of Variable Correlation Stock Index -0.0184 with

Expected Prices

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Cash rate Money Supply Gross domestic product Disposable saving Price level Finance Price Operating Surplus

0.0251 0.0372 -0.0068 -0.0039 -0.041 -0.0272 0.0295

The data shortage lead to considered two variables at a time. The variables considered at a time were more and data needed for one VAR is usually square of number of variables times the lag considered. The lag considered was 10 except for price of financial goods (4 lags; data was 34 observations). The variables were 9.This makes 9*9*10 = 810 observation. Even at a lag 1 is would be 81 observations as opposed to 60 which were present. The reason of quarterly data is that gross domestic product data is available only quarterly. The fore mentioned technique suggests that using one variable at a time is acceptable.

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