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Output and stock prices: an examination of the relationship over 200 years

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Using data spanning 200 years we examine the nature of the long-run cointegrating behaviour between real output and real stock prices. A standard cointegration framework demonstrates that such a long-run relationship exists with both variables exhibiting significant equilibrium reversion, albeit quicker for stock prices. To further examine the nature of the equilibrium we consider two exercises. First, we consider possible time-variation in the cointegrating vector, for which we find evidence. Second, we separate the fundamental and bubble components within stock prices. Our results indicate that failure to account for these two issues can lead to errors in determining the nature of any disequilibrium between the two series, including the size and sign of the disequilibrium. Furthermore, our results reveal that the bubble component has a significant impact on future values of output growth. An out-of-sample forecasting exercise for returns shows that the time-varying model performs best and may beat the market. These results have implications for policy-makers and market practitioners alike. For the former, they are interested in the impact of stock market behaviour of the real economy, while the latter group are interested in any possible information about future stock prices.
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Keywords: C22; E20; G12; GDP; bubbles; cointegration; stock prices; time-variation

Document Type: Research Article

Affiliations: 1: Accounting and Finance Division,Stirling Management School, University of Stirling, Stirling FK9 4LA, UK 2: Department of Economics,University of Nebraska at Omaha, RH-512K, Omaha 68182, USA

Publication date: 01 October 2012

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