Dynamic relationships between financial conditions index and stock returns

Abstract

Stock return predictability has been extensively considered as a stylized reality. Theories indicate that returns should change along the time, and various studies have presented evidence on this point. On the other hand, there is an optimal portfolio in each regime, and one cannot claim that a specific portfolio can minimize risk and returns in each regime. On the other hand, the financial conditions index (FCI) is an important index to specify monetary policy conditions. Regarding the importance of the issue, this research aims to present a comprehensive index, including all monetary transmission mechanisms. In this regard, it is attempted to improve the efficiency of stock return predictability in Iran's economy by incorporating an FCI and identifying relationships between FCI and stock returns using the TVP-DMA model, which can resolve shortcomings of traditional models. The study is applied research in terms of purpose. Seasonal data over the period of April 1991 to July 2019 is used. The results based on TPV, DMS, and DMA models indicate that liquidity growth rate, economic growth rate, unemployment rate, exchange rate, financial condition index, oil revenues, misery index, and budget deficit, has significantly affected factors of stock returns in 30, 50, 11, 49, 66, 54, 7, and 84 periods of 104 periods, respectively. Accordingly, budget deficit, financial condition index, oil revenues, and economic growth are the most effective factors of stock returns predictability in Iran. Further, the incorporation of flexibility in coefficients of the financial development index leads to higher forecast accuracy.