Do Industries Lead Stock Markets?: Harrison Hong, Walter Torous, Rossen Valkanov
Do Industries Lead Stock Markets?: Harrison Hong, Walter Torous, Rossen Valkanov
Do Industries Lead Stock Markets?: Harrison Hong, Walter Torous, Rossen Valkanov
Received 16 June 2004; received in revised form 28 July 2005; accepted 9 September 2005
Available online 22 September 2006
Abstract
We investigate whether the returns of industry portfolios predict stock market movements. In the
US, a signicant number of industry returns, including retail, services, commercial real estate, metal,
and petroleum, forecast the stock market by up to two months. Moreover, the propensity of an
industry to predict the market is correlated with its propensity to forecast various indicators of
economic activity. The eight largest non-US stock markets show remarkably similar patterns. These
ndings suggest that stock markets react with a delay to information contained in industry returns
about their fundamentals and that information diffuses only gradually across markets.
r 2006 Elsevier B.V. All rights reserved.
JEL classifications: G12; G14; G15; E44
Keywords: Asset pricing; Information and market efciency; Financial markets and macroeconomy; International
nancial markets
We are grateful to Jeremy Stein and a referee for many insightful comments. We also thank John Campbell,
Kent Daniel, Ken French, Owen Lamont, Toby Moskowitz, Sheridan Titman, Rob Engle, Matthew Richardson,
David Hirshleifer, Matthew Slaughter, Will Goetzmann, Mark Grinblatt, and participants at the 2004 AFA
meetings, Berkeley-MIT-Texas Real Estate Research Conference, Goldman Sachs, Columbia, Dartmouth,
Harvard Business School, NYU, Rice, and Yale for helpful comments. Hong acknowledges support from an NSF
grant. Valkanov acknowledges support from the Anderson School at UCLA.
Corresponding author.
E-mail address: hhong@princeton.edu (H. Hong).
0304-405X/$ - see front matter r 2006 Elsevier B.V. All rights reserved.
doi:10.1016/j.jneco.2005.09.010
ARTICLE IN PRESS
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1. Introduction
In this paper, we investigate whether the returns of industry portfolios are able to predict
the movements of stock markets. We begin our analysis with the US stock market. Over
the period 19462002, we nd that 14 out of 34 industries, including commercial real
estate, petroleum, metal, retail, nancial, and services, can predict market movements by
one month. A number of others such as petroleum, metal, and nancial can forecast the
market even two months ahead. After adding a variety of well-known proxies for risk and
liquidity in our regressions as well as lagged market returns, the predictability of the
market by these 14 industry portfolios remains statistically signicant. We have also done
numerical simulations to gauge just how many industries will (with statistical signicance)
forecast the market simply by chance, and in only 0.04% of the simulations are 14 or more
industries able to forecast the market and on average, only ve (in contrast to the 14 we
nd) are able to do so at the 10% level of signicance.
In addition, we provide a few metrics regarding the statistical and economic signicance
of the documented predictability. First, we examine the ability of these industries to predict
the market in comparison to well-known predictors such as ination, default spread, and
dividend yield and nd comparable forecasting power. Second, we show that a portfolio
incorporating information in past industry returns can lead under certain circumstances to
a higher Sharpe ratio than simply holding the market. And third, we extend our analysis to
each of the largest eight stock markets outside of the US, including Japan, Canada,
Australia, UK, Netherlands, Switzerland, France, and Germany. In contrast to the US,
these time series are limited to the period of 19732002 and we are unable to obtain the
same set of controls (e.g., market dividend yield, default spread). With these caveats in
mind, we nd that the US results hold up remarkably well for the rest of the world.
Our investigation is motivated by recent theories that explore the implications of limited
information-processing capacity for asset prices. Many economists have recognized for
some time that investors, rather than possessing unlimited processing capacity, are better
characterized as being only boundedly rational (see Shiller, 2000; Sims, 2001). Even from
casual observation, few traders can pay attention to all sources of information, much less
understand their impact on the prices of the assets that they trade. Indeed, a large literature
in psychology documents the extent to which even attention is a precious cognitive
resource (see, e.g., Kahneman, 1973; Nisbett and Ross, 1980).
More specically, our investigation builds on recent work by Merton (1987) and Hong
and Stein (1999). Merton develops a static model of multiple stocks in which investors have
information about only a limited number of stocks and trade only those that they have
information about. As a result, stocks that are less recognized by investors have a smaller
investor base (neglected stocks) and trade at a greater discount because of limited risksharing. Hong and Stein develop a dynamic model of a single asset in which information
gradually diffuses across the investment public and investors are unable to perform the
rational expectations trick of extracting information from prices. As a result, the price
underreacts to the information and there is stock return predictability.1
The hypothesis that guides our analysis of whether industries lead stock markets is that
the gradual diffusion of information across asset markets leads to cross-asset return
1
For other models of limited market participation, see Brennan (1975) and Allen and Gale (1994). For related
models of limited attention, see, e.g., Peng and Xiong (2002) and Hirshleifer, Lim, and Teoh (2002).
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