Is there a long-run relationship between stock prices and economic activity and are stock returns a leading indicator for economic growth? : Evidence from the Scandinavian countries: Sweden, Norway and Denmark
Abstract: The purpose of this paper is twofold. First, the Johansen cointegration framework is applied to analyze the long-run relationship between stock prices and economic activity, using GDP as a proxy. In consideration of a long-run relationship a vector error correction model (VECM) is estimated to analyze the parameters of cointegration. Secondly, the paper proceeds by estimating a vector autoregressive model (VAR) in order to analyse the relationship between stock returns and economic growth, measured as GDP-growth, and its dynamics. Further, a Granger-causality framework is adopted along with a recursive forecast framework to investigate if stock returns improve the forecast of economic growth. These analyses are carried out for Sweden, Norway and Denmark using a time period ranging from 1996Q1 to 2020Q1. Evidence from the Johansen cointegration framework verifies a long-run relationship between stock prices and economic activity in Sweden, which supports that dividends, on average, grow with economic activity over time. However, results provide no evidence of a long-run relationship in Norway and Denmark. Furthermore, results from the Granger-causality framework verifies that stock returns are a significant explanatory variable for economic growth in all countries. Despite this, the recursive forecast framework shows that the VAR-model, which in addition to GDP-growth also includes stock returns, does not improve the forecast of economic growth in comparison to an AR(1)-benchmark model including only GDP-growth. Further, the trivariate VAR-model, which incorporates not only GDP-growth and stock returns but also yield spread, shows similar results, hence it cannot outperform the benchmark model.
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