Sunday, June 30, 2013

Do Industries Lead Stock Markets? - Rady School of Management

Do Industries Lead Stock Markets? - Rady School of ManagementDo Industries Lead Stock Markets? Harrison Hong Princeton University Walter Torous UCLA Rossen Valkanov UCLA First Draft: July 31, 2002 This Draft: November 24, 2004 Abstract: We investigate whether the returns of industry portfolios are able to predict the movements of stock markets. In the U.S., we find that a significant number of industry returns, including retail, services, commercial real estate, metal and petroleum, can forecast the stock market by up to two months. Moreover, the propensity of an industry to predict the market is correlated with its propensity to forecast various indicators of economic activity such as industrial production growth. When we extend our analysis to the eight largest stock markets outside of the U.S., we find remarkably similar

patterns. These findings suggest that stock markets react with a delay to information contained in industry returns about their fundamentals and that information diffuses only gradually across markets. JEL: G12, G14, E44, G15 Keywords: Asset Pricing, Information and Market Efficiency, Financial Markets and Macroeconomy, International Financial Markets _____________________ We are grateful to Jeremy Stein and a referee for many insightful comments. We also thank John Campbell, Kent Daniel, Ken French, Owen Lamont, Toby Moskowitz, Sheridan Titman, Rob Engle, Matthew Richardson, David Hirshleifer, Matthew Slaughter, Will Goetzmann, Mark Grinblatt, our discussant at the 2004 AFA meetings in San Diego and participants at the Berkeley-MIT-Texas Real Estate Research Conference, Columbia, Dartmouth, Harvard Business School, NYU, Rice, and Yale for helpful comments. Do Industries Lead Stock Markets? Abstract: We investigate whether the returns of industry portfolios are able to predict the movements of stock markets. In the U.S., we find that a significant number of industry returns, including retail, services, commercial real estate, metal and petroleum, can forecast the stock market by up to two months. Moreover, the propensity of an industry to predict the market is correlated with its propensity to forecast various indicators of economic activity such as industrial production growth. When we extend our analysis to the eight largest stock markets outside of the U.S., we find remarkably similar patterns. These findings suggest that stock markets react with a delay to information contained in industry returns about their fundamentals and that information diffuses only gradually across markets. JEL: G12, G14, E44, G15 Keywords: Asset Pricing, Information and Market Efficiency, Financial Markets and Macroeconomy, International Financial Markets 1 In this paper, we investigate whether the returns of industry portfolios are able to predict the movements of stock markets. We begin our analysis with the U.S. stock market. Over the period of 1946 to 2002, we find that fourteen out of thirty-four industries, including commercial real estate, petroleum, metal, retail, financial and services, can predict market movements by one month. A number of others such as petroleum, metal and financial can forecast the market even two months ahead. After adding a variety of well-known proxies for risk and liquidity in our regressions as well as lagged market returns, the predictability of the market by these fourteen industry portfolios remains statistically significant. We have also done numerical simulations to gauge just how many industries will (with statistical significance) forecast the market simply by...

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