How Inflation, Market Capitalization, Industrial Production and the Economic Sentiment Indicator Affect the EU-12 Stock Markets

Abstract

1. Introductory observations and study objectives Stock market price movements, like mutual funds, investment firms, and hedge funds, constitute a particularly popular research field among academics and individual and institutional investors. Despite the fact that certain variables affect stock markets similarly, the degree of this dependence is not determined in a rigorous manner. Indeed, stock markets are included in a globalized environment, which means that they move in a similar mode; however, the country-specific, geographic, economic, political, and social factors also have their particular effect on markets. The importance of capital markets is confirmed by the extensive volume of trades taking place globally, while the number and type of private and institutional investors has considerably increased. Consequently, the international literature consists of a serious amount of research papers that use different statistical approaches to identify the relationship between stock markets and their defining factors. The present study focuses specifically on Europe, and its main objective is to determine the effects of inflation (INF), market capitalization (MC), industrial production (IP), and the economic sentiment indicator (ESI) on stock market indices, using a panel of 12 European countries (5) during the period 2000-2005. The criterion for selection of the countries is a shared currency, which in turn indicates similar macroeconomic policies and characteristics. Additionally, the overarching role of the four variables previously discussed is confirmed theoretically and empirically, since numerous empirical studies have established a link between these macroeconomic factors and stock markets (Flannery and Protopapadakis, 2002, Thalassinos, 2006). Many studies, using various econometric methods, confirm that stock returns are negatively related to the general level of prices (Geske and Roll, 1983; Pearce and Roley, 1983; Fama, 1981; Bodie, 1976). On the other hand, a questionable relationship between stock market prices and the national industrial production index is identified, which represents general industrial growth. Last but not least, empirical examination of stock market behavior has exposed a strong link between stock market prices and both market capitalization and the economic sentiment indicator (Estrella and Mishkin, 1997; Harvey, 1988). Taking into account the significance of these four factors for market prices, we establish that a considerable amount of market variation can be explained by applying a statistical model that simultaneously examines the above factors. Therefore, the relationship between the European stock markets and the selected fundamentals is investigated through a panel data analysis. The rest of the paper is organized as follows: in the second section we present previous empirical research into the impact of the particular variables on the EU-12 stock market indices. The data and the structure of the applied model are described in the third section, while the regressions and the estimation of the model together with an interpretation of the results are presented in the fourth section. The final section of the paper gives the conclusions of our study and provides suggestions for further research. 2. Literature review The significance of inflation, market capitalization, industrial production, and the economic sentiment indicator for stock market indices has been examined extensively in the international literature. Numerous researchers consider any of these factors to be a reliable indicator of future stock market movements. However, the methodological approaches among the empirical studies are not similar, since different statistical models are applied to capture the significance of each variable in the determination of stock prices. The major findings regarding the correlation between these variables and the stock market are presented here. …