The long-run relationship between stock prices and goods prices: New evidence from panel cointegration

Abstract

We examine the long-run relationship between stock prices and goods prices to gauge whether stock market investment can hedge against inflation. Data from 16 OECD countries over the period 1970–2006 are used. We account for different inflation regimes with the use of sub-sample regressions, while maintaining the power of tests in small sample sizes by combining time-series data across our sample countries in a panel unit root and panel cointegration econometric framework. The evidence supports a positive long-run relationship between goods prices and stock prices with the estimated goods price coefficient being in line with the generalized Fisher hypothesis.

Introduction

Increases in energy and food prices in the last years along with the gradual evaporation of the inflation-calming effects of the ‘globalization’ supply shock, that major economies have been enjoying ever since the early 1990s, reminded investors of the inflation threat. Although few economists would currently argue that a return to the highly inflationary 1970s is possible, nevertheless from an investor's point of view a re-examination of whether stock prices maintain their value relative to goods prices becomes increasingly important. According to the generalized Fisher effect (GFE) since stocks represent claims to real assets their real rate of return should be uncorrelated to the underlying inflation rate, a prediction consistent with the classical view of mutually independent nominal and real sectors (Fisher, 1930).

The perception of stocks as inflation-hedging investment was challenged by several empirical studies that offered compelling evidence supporting inflation's negative effect on short-horizon (holding period of 1 year or less) stock returns. However, given that the Fisher hypothesis is an equilibrium relationship expected to hold in the long-run, the apparent failure to verify it using short-horizon regressions is not all surprising. Indeed, existing empirical evidence using the long-horizon regression methodology supports the existence of a positive long-run relationship between stock returns and inflation with estimated coefficients broadly in line with the GFE (see among others, Boudoukh and Richardson, 1993). Nevertheless, since goods prices and stock prices are both known to be integrated processes with infinitely long memory, estimating regressions in terms of their first of higher order differences (corresponding to increasing holding horizons) implies that long-run information is only partially accounted for (Anari and Kolari, 2001).

Hence, following developments in the econometric modeling of non-stationary time-series recent literature on the long-run hedging properties of stock market investment has focused on modeling the levels of goods and stock prices using the cointegration framework developed by Johansen (1988). Luintel and Paudyal's (2006) results indicate that UK stocks provide a good inflation-hedge over the long-run after allowing for structural breaks in the cointegrating relationship.

In this paper we undertake an alternative approach in tackling the possibility of structural change in the long-run relationship between stock prices and goods prices. Our approach entails conducting the empirical analysis not only across the full sample (1970–2006), but also across three sub-periods that correspond to three radically different inflation regimes in our dataset of 16 OECD countries: high inflation (1970–1979), inflation moderation (1980–1989), inflation control (1990–2006). This will allow us to examine the process of disinflation affected the long-run elasticity of stock prices with respect to goods prices.¹

Breaking down the overall sample in three sub-samples significantly reduces the length of the dataset and it is well known that the power of time-series unit root and cointegration tests is conditional upon the use of long-span data (see among others, Zhou, 2001).² Hence, unlike previous studies on the GFE, our unit root and cointegration analysis will be analyzed within a panel framework to utilize the dataset in the most efficient manner. We are the first study to our knowledge that examines the long-run relationship between stock prices and goods prices using panel cointegration.³ We will employ the panel unit root test established by Maddala and Wu (1999) and panel cointegration tests developed by Levin et al. (2002), Harris and Tzavalis (1999) and Maddala and Kim (1998). Cointegrating vectors are estimated using the fully modified OLS estimation technique for heterogeneous cointegrated panels developed by Pedroni (2000). This methodology allows consistent and efficient estimation of cointegrating vectors. In addition, it deals with the possible endogeneity in the stock price – goods price relation and it encapsulates the time-series properties of the data in that integration–cointegration properties are explicitly accounted for.

Our dataset includes countries that have adopted inflation targeting monetary policy regimes at some point over the 1990s or early 2000s. An interesting question for stock market investors in terms of international investment allocation is whether the inflation-hedging property of stocks is affected by the underlying monetary policy regime. Therefore, in order to provide an answer to the aforementioned question we will break down the overall panel in two sub-panels: a panel including inflation targeting countries and a panel consisting of the remaining countries. The results from this analysis are also relevant to the discussion about the broader potential benefits of inflation targeting, given that if the long-run Fisherian elasticity of stocks is higher for targeting countries, this could be interpreted as an additional benefit from adopting targeting policies. Finally, we arrange the sample in a panel of high inflation countries and a panel of low inflation countries. This classification will enable us to further investigate whether the long-run relationship between stock prices and goods prices is affected by the underlying rate of inflation.⁴

The rest of the paper is structured as follows. The following section, presents an overview of the results from empirical tests of the generalized Fisher hypothesis. Section 3 discusses our dataset, while in Section 4 we present the panel unit root test results (4.1), panel cointegration results (4.2), and the estimates of the long-run relationship (4.3), respectively. Section 5 concludes.