The reason for conducting this research is to study the relationship between stock market index performance and macroeconomic variables like inflation rate, base lending rate (BLR), gross domestic product (GDP) of developed countries (UK,US) also developing countries (Malaysia, Indonesia). The stock markets that will be studied in this research are FTSE 100, S&P 500, FBM KLCI and JCI. Before going further, lets take a look at the history of the past global stock market performance.
Over the past 10 years according to article in eHow.com, the stock market had facing and witnessing four types of environments bull market, 2000 to 2002 (bear market), 2003 to 2007 (bull market) and finally the end of 2007 (bear market) featuring a high-to-low price decline of more than 50% on the major stock indices. Shabri & Salina (2007) said that from data obtained in Bloomberg Database (2008) in July 25, until December 31, 2008, the global financial crisis, severely effected US stock market by a decline in S&P 500 by 40.50%. The FTSE 100 of the UK stock market plunged by 31.30%, KLSE or present known as FBM KLCI for Malaysia decreased by 36.45% and JCI for Indonesia declined by 43.39%. At the end of the 20th century, American and global stock markets were in the largest bull market in world history. In 1999, the technology-heavy Nasdaq doubled on account of the dotcom speculative frenzy. The S&P500 and Dow Jones Industrial Average also pushed higher but at a slower pace. Then, in 2000, investors realized that the bull market had entered bubble territory, with stock prices having been bid up to ridiculously high valuations. An incredibly strong bear market, wiping out billions of dollars worth of paper profits. While this phenomenon closely identified with the dotcom crash, similar losses were experienced during the subprime crash of 2007 to 2008.
Based from the past 10 years, this study of the relationship between stock market performance and microeconomic variables over the developed countries and developing countries is important because stock market performance of a country shows the overall conditions of the country economy. This study will show that different macroeconomic variables have different impacts on the country stock market performance.
According to EconomyWatch, stock market performance is the indicator of the stock market as a whole or of a specific stock. The movement in the price of a stock and the index gives the idea of the near future trend of the stock and works as an indicator of the overall health of the economy. Stock prices are an indicator of the performance of the stock. In this research, the researher will use the quarterly closing stock prices from 2000 until 2010.
Stock market performance is affected by many factors such as economical, political, international, and company-specific issues. In this research, the researcher will only focus on the microeconomic factors that consisted of the independent variables as mentioned in the first paragraph above. The reason why the microeconomic variables are chosen because it supported by this statement, the tool to measure the performance of economy includes GDP, rate of inflation, fiscal position and many other factors (Pal & Mittal, 2008).
If the performance of an economy is good then the stock market performance is also good. For developing countries like Malaysia and Indonesia to achieved developed countries status like the United Kingdom (UK) and the United States (US) a clearer understanding of economy should be emphasized. According to (Pal & Mittal, 2008), a condusive macroeconomic environment promotes the profitability of business, which helps them to the stage of easy access of securities for sustained growth. If the economic performances are not up to the mark then the stock market is most likely to under perform and might see a downward trend. Hence, overall economic and stock specific performance influences performance of the market. Thus, stock market performance acts as the barometer of the economy as a whole.
1.2 Background of the stock markets
The FTSE 100 Index is also called FTSE 100. It is a share index of the 100 most highly capitalised UK companies listed on the London Stock Exchange. The index is maintained by the FTSE Group, an independent company which originated as a joint venture between the Financial Times and the London Stock Exchange. The index began on 3 January 1984 and the 100 companies must meet a number of requirements set out by the FTSE Group, including having a full listing on the London Stock Exchange with a Sterling or Euro denominated price and meeting certain tests on nationality, free float, and liquidity. The companies listed on this index also must by law include the abbreviation 'plc' at the end of their name, indicating their status of public limited company. The index is the most widely used of the FTSE Group's indices, and is frequently reported (e.g. on UK news bulletins) as a measure of business prosperity.
Standard & Poor's introduced its first stock index in 1923. Before 1957, its primary daily stock market index was the "S&P 90," a value weighted index based on 90 stocks. The S&P 500 index in its present form began on March 4, 1957. The S&P 500 is a free-float capitalization-weighted index of the prices of 500 large-cap common stocks actively traded in the United States either of the New York Stock Exchange and the NASDAQ. The index focus is U.S.-based headquarters companies. If a new company listed shifts its headquarters to other countries then it will replaced by new US company. The components of the S&P 500 are selected by committee. The committee selects the companies that represented the industries in the United States (US) economy. Furthermore, companies must be traded publicly, those companies that are privately or mutually held and stocks that do not have sufficient liquidity are not in the index. The S&P 500 is considered a bellwether for the American economy. Bellwether is any entity in a given arena that serves to create or influence trends or to predict future happenings. It means that the economy performance of the US depends on the performances of the companies listed on the index.
The Kuala Lumpur Composite Index (KLCI) was a stock market index generally accepted as the local stock market barometer. It was introduced in 1986 to answer the need for a stock market index which would serve as an accurate performance indicator of the Malaysian stock market as well as the economy. From 6 July 2009, Malaysia's primary benchmark index, the Kuala Lumpur Composite Index (KLCI), will adopt the FTSE global index standard and will be known as the FTSE Bursa Malaysia KLCI (FBM KLCI). One of the major features is that the FBM KLCI will be leaner and more robust, consisting of the 30 largest eligible companies by market capitalisation instead of the current 100 stocks in the KLCI. The idea is that the investors can manage the stock only to 30 stocks rather than having to own 100 different stocks which costly to maintain and some of the smaller stocks can be quite illiquid.
Capital markets or the stock exchange in Indonesia has been present since the Dutch colonial era and precisely in 1912 in Batavia for the benefit of the colonial government or VOC. After the World War I and II and the transfer of power from the colonial government to the government of the Republic of Indonesia, 10 August 1977 the Stock Exchange re-opened by President Soeharto run under Bapepam (Capital Market Executive Agency). On July 13, 1992, the exchange was privatized under the ownership of Jakarta Exchange Inc. As a result, the functions of Bapepam changed to become the Capital Market Supervisory Agency. Later in September 2007, Jakarta Stock Exchange and Surabaya Stock Exchange merged and named Indonesian Stock Exchange by Indonesian Minister of Finance. The Indonesia Stock Exchange had 341 listed companies with a combined market capitalization of $269.9 billion. Two of the primary stock market indices are Jakarta Composite Index and the Jakarta Islamic Index (JII). However I will focus on the Jakarta Composite Index for this research. The Jakarta Composite Index is an index of all stocks that trade on the Indonesia Stock Exchange.
CHAPTER 2
LITERATURE REVIEW
2.0 Literature review
Based from the research readings of various journals from other researchers, it is found out that several researchers have attempted to establish the relationship between macroeconomic variables (inflation rate, interest (BLR), gross domestic product (GDP) ) and stock market price index performances. Maysami et all. (2004) examined the relationship between the macroeconomic variables and the sector stock index represented by SES All-S Equities Finance Index, SES All-S Equities Property index and SES All-S Equities Hotel Index as well as Singapore composite index using Johansen's (1990) VECM. It concluded that Singapore stock market and all the SES All-S Equities Property Index formed significant relationship with all microeconomic variables identified, while SES All-S Equities Finance Index and SES All-S Equities Hotel Index had significant relationship with only select variables (interest rate, inflation, exchange rate, industrial production and money supply.
Ibrahim (1999), investigates the dynamic interactions between seven macroeconomic variables and the stock prices for an emerging market in Malaysia, using co-integration and Ganger causality tests. The result strongly suggests informational inefficiency in the Malaysia market.
Mutehersea T.K. and Naka A. (1995) TSE Index was co-integrated with money supply, inflation rate, real economic activity, long term government bond, exchange rate and interest rate.
Asikoglu and Ercan (1992), they investigated the relationship between inflation and stock prices at the industry level for the US economy, using the flow- through constant hypothesis of Estep and Hanson (1980). There is positive relationship between changes in share prices and the flow through coefficient. Investors would be willing to pay a higher price when a higher percentage of a given inflation rate flows trough equities in the form of earning growth.
Marshall (1992), his model in "Inflation and Asset Return in a Monetary Economy" journal shows that share prices and the expected inflation rate should negatively correlated, and it predicts that the inflation-asset return correlation will be more strongly negative when the inflation is generated by fluctuations in real economic activity than when it is generated by monetary fluctuations
(Jaffe and Mandelker, 1976: Bodie, 1975; Nelson 1976; Fama and Swert, 1977), argued that inflation and stock prices are inversely related. Fama (1981) and , Gertler and Grinols (1982), and Solnik (1983) also achieved negative result relationship. These results according to Charles K.D.Adjasi (2009) led to several hypotheses emerging to explain the negative relationship between stock returns and inflation. The result from Anthony, K.C. (2008) study, the inflation level does not have any effect on market performance but rather it takes time for the market to react to the changes in the inflation rate.
Natasi M. (1998) said that stock value (price of common stock) depends on discount rate. When inflation increase the discount rate increase thus the price of stock will decline. The result shows slight negative correlation exit between inflation and stock price.
More from Udegnunam R.I and Eriki P. (2001), they used (OLS) method to study the empirical relation and stock prices in Nigeria consisted of annual time series of the variables. The evidence shows that inflation exerts significant measure of negative influence on the Nigerian markets.
Winger and Frasca (2000) in Personal Finance, An Integrated planning Approach said that changes in Real GDP provide measurement of the country's economic performance. Studies prove that changes in stock price and GDP have a positive relationship.
Bank Negara Malaysia in their annual report 2003 stated when GDP increase, stock price will increase and vice versa for Malaysia market.
Winter and Michael (1990), in their study on the relationship between the fundamental economic variables and stock prices in the USA during the year 1967 to 1986, by using the Time Series Regression Model as a method of study, the result indicates that significant movement in stock prices are explainable by changes in two fundamental economic variables that are GNP and real interest rate.
Dr. Othman Yong (1995), interest rate can affect the stock market by making alternative investment become more or less attractive to investors. High interest rate, the cost of borrowing will also high so the lower the number of investors who are willing to employed borrowed fund to invest in stock market.
Dinenis and Staikauras (1998) examined the impact of interest rate changes on common stock return of portfolio of financial institutions in UK using two-index model and three index model. The result 1) significant relationship between common stock returns and changes in interest rate.2) Common stock returns and variability of interest rate are related with significant positive coefficient.
Anthony, K.C. (2008) in his study findings revealed that lending rates from deposit money banks have an adverse effect on stock market performance and particularly serve as major hindrance to business growth in Ghana. Furthermore, from Coleman & Tetly (2008) they studied the impact of macroeconomic indicators on the Ghana Stock Exchange (GSE) and the results showed lending rates from deposit money banks have an adverse impact from stock market performance.
Fama, Eugene and Schwert (1977) in Asset Returns and Inflation, There is evidence that stock returns are negatively related to changes in the interest rate.
Lim (1993), in The Efficient Market Hypothesis and Share Price Behavior on KLSE journal stated that KLSE was in weak form. Price movement does not follow any pattern, which may be extrapolated, from past information chart technique are unreliable.
Karam, P. and Ruhee, M. (2008) in their study finds that there is co-intergration between macroeconomic variables and Indian Stock Indices which is indicative of long run relationship. Rate of inflation have significant impact on BSE Sensex and S&P CNX Nifty. Interest rate has impact on S&P CNX Nifty only. Changing gross domestic savings is observed as insignificantly associated with both the BSE Sensex and S&P CNX Nifty. On whole, the capital market indices are dependent on macroeconomic variables even though the same might not statistically significant in all cases.
