The Link between the Rate of Growth of Stock Prices and the Rate of Growth of GNP in the United States: A Granger Causality Test

Abstract

that changes in stock prices predict the direction of subsequent changes in the level of economic activity i.e., future economic growth rates. The fact that stock prices are a component of the U.S. Index of Leading Economic Indicator suggests that this notion is also accepted at the official level. An examination of historical data, however, yields mixed results with respect to the stock market performance as a predictor of future economic growth. Although recessions have been typically preceded by significant reductions in stock prices in some cases the stock market generated i.e., it forecasted non-recessions and in some other cases it totally missed the downturn in the level of economic activity. A recent study by Peek and Rosengren (1988), for example, indicates that between 1955-86, out of eleven cases in which (real) Standard and Poor's Composite Index of 500 stocks (S&P500) has declined by more than 7 percent (i.e., the smallest pre-recession decline in S&P500) only six were followed by reces sions. (All the six recoveries, however, were correctly anticipated by the stock market). According to the authors, when the changes in S&P500 are used to predict growth slowdowns instead of recessions, three of the five false signals are eliminated. In a similar study, Barro (1989) finds that stock market performance (as measured by a one-year lagged value of annual stock return) successfully predicted eight out of nine recessions over the period 1926-87 (with the 1980-82 recession being the only excep tion), but it also predicted three recessions (for the years 1963, 1967, and 1978) that did not occur.