Determinants of Common Stock Prices: A Time Series Analysis

The authors begin with a quick history of the studies around money supply and stock prices, noting that some researches have confirmed an unidirectional causation while others have rebuffed it.  At stake is whether the efficient market hypothesis holds (i.e., that only current and future estimates of money supply levels dictate stock prices); if future stock prices are caused by changes in the money supply, then one would reject the efficient market hypothesis and abnormal trading profits could be earned.

The authors use several determinants of stock prices (e.g., money supply, rate of change in money supply, corporate interest rate, and a measure of risk) to see if there is a causal relationship between them and stock prices.  They form a set of 4 equations for each determinant of stock prices.  The 1st equation includes current and lagged values of the determinant as independent variables; the 2nd equation includes, current, lagged, and future values of the determinant as independent variables; and the 3rd and 4th equations reverse the dependent and independent variables of equations 1 and 2.

Through these equations, the authors determine that there is a statistical relationship between the determinants and stock prices.  However, they find that there is no significant causality relationship running from money supply to stock prices; in fact, they find that current stock prices have an influence on future money supply.  Which is consistent with the efficient market hypothesis, whereby, future changes are anticipated by stock price movements.

KRAFT, J., & KRAFT, A. (1977). Determinants of Common Stock Prices: A Time Series Analysis. Journal of Finance, 32(2), 417–425.