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Stock-bond correlation and the bond quality ratio: Removing the discount factor to generate a “deflated” stock index

Author

Listed:
  • Andrea Terzi

    () (DISCE, Università Cattolica)

  • Giovanni Verga

    () (Università di Parma)

Abstract

This paper investigates the cyclical co-movements between US stocks and interest rates by testing a simple model where divergence between stock and bond price behavior is explained by “stock market strength,” where the latter depends on the market climate about future corporate profits—as captured by the corporate bond quality ratio—and an unexplained stock market sentiment. Using two different regression techniques to check for robustness, we find evidence of a statistically significant cyclical correlation between stocks and bonds. On the basis of this finding, we then present a methodology to “deflate” a stock price index such that we can compare stock market strength over time. This is obtained by removing the effect of a changing discount rate—as measured by our regressions—on stock prices. For example, viewed in this light, the past five years in the US stock market reveal a wider fluctuation in stock market strength than we can observe on the basis of stock price indices alone.

Suggested Citation

  • Andrea Terzi & Giovanni Verga, 2006. "Stock-bond correlation and the bond quality ratio: Removing the discount factor to generate a “deflated” stock index," DISCE - Quaderni dell'Istituto di Economia e Finanza ief0067, Università Cattolica del Sacro Cuore, Dipartimenti e Istituti di Scienze Economiche (DISCE).
  • Handle: RePEc:ctc:serie3:ief0067
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    File URL: http://www.unicatt.it/Istituti/EconomiaFinanza/Quaderni/ief0067.pdf
    File Function: First version, 2006
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    Cited by:

    1. Sandro Brusco & Luca Colombo & Umberto Galmarini, 2010. "Local Governments Tax Autonomy, Lobbying, and Welfare," Department of Economics Working Papers 10-01, Stony Brook University, Department of Economics.
    2. Angelo Baglioni, 2006. "Entry into a network industry: consumers’ expectations and firms’ pricing policies," DISCE - Quaderni dell'Istituto di Economia e Finanza ief69, Università Cattolica del Sacro Cuore, Dipartimenti e Istituti di Scienze Economiche (DISCE).
    3. Maria Flavia Ambrosanio & Massimo Bordignon & Floriana Cerniglia, 2010. "Constitutional Reforms, Fiscal Decentralization and Regional Fiscal Flows in Italy," Chapters,in: The Political Economy of Inter-Regional Fiscal Flows, chapter 4 Edward Elgar Publishing.
    4. Luca Colombo & Herbert Dawid & Kordian Kabus, 2012. "When do thick venture capital markets foster innovation? An evolutionary analysis," Journal of Evolutionary Economics, Springer, vol. 22(1), pages 79-108, January.
    5. Stefano Colombo, 2008. "Discriminatory prices, endogenous locations and the Prisoner Dilemma problem," DISCE - Quaderni dell'Istituto di Economia e Finanza ief0079, Università Cattolica del Sacro Cuore, Dipartimenti e Istituti di Scienze Economiche (DISCE).
    6. Baglioni, Angelo & Monticini, Andrea, 2010. "The intraday interest rate under a liquidity crisis: The case of August 2007," Economics Letters, Elsevier, vol. 107(2), pages 198-200, May.
    7. Giuseppe Mastromatteo, 2011. "H.P. Minsky And Policies To Countervail Crises," DISCE - Quaderni dell'Istituto di Economia e Finanza ief0102, Università Cattolica del Sacro Cuore, Dipartimenti e Istituti di Scienze Economiche (DISCE).
    8. Giuseppe Mastromatteo, 2011. "The Debate on the Crisis: Recent Reappraisals of the Concept of Functional Finance," DISCE - Quaderni dell'Istituto di Economia e Finanza ief0105, Università Cattolica del Sacro Cuore, Dipartimenti e Istituti di Scienze Economiche (DISCE).

    More about this item

    Keywords

    Stock-bond correlation; Market sentiment; Stock price.;

    JEL classification:

    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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