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THE FINANCIAL REVIEW Voz.. 31 No. 2 MAY 1996 PP. 287-312

Market Dependence and Economic Events

Abstract Recent studies on stock market pricing have rejected the random walk model for short-berm periods and have concentrated on long-term persistent or mean-reverting dependence. The problem with these studies is that their statistical results can be biased by the shorter term deQendenc. Rather than trying to develop a unied theory that explains both short- and long-term dependence, cufrent studies use different methodologies to correct for the short-term dependence while trying to test for long-term dependence. This paper uses a sequential information theory to focus attention on short-term dependence effects. theory states that the market process is a nonstationary mean process surrounded by a nonstationary aubocovariance error process. A nonstationary mean process implies short-term dependence resulting from clianging economic events (new information). Long-term persistent dependence then derives from nonperiodic economic cycles. A new empirical approach, a cross-sectional autocorrelation coefficient is used since it is free from the stationarity problems of previous techniques.
*Villanova University, Villanova, PA 19085 This paper is derived from the authors dissertation (Nawrocki [31]). The review of the literature and the data sets have been updated. 'I'he author would like te fhe rnembers of his dissertation committee: George C. Philippatos, John R. Ezzell, Lawrence Hrebiniak, and to honor the memory of Joseph Bradley and Robert J. Mowitz. The author is grateful to the two anonymous referees of this journal and Steven J. Cochranfor their comments on earlielf vefsjons of thie peper. Computer support was provided by San Diego State University and Villanova University."'he author is solely responsible for all opinions and errors that accompany the paper.

287 Copyright@ 2001 _ All Rights Reseved.

Introduction

When an airliner is flying at 35,000 feet, the coast~ line below looks very smooth. However, as the

airliner reduces altitude, the smooth coastline starts to break up into jagged patterns. As the airliner flies closer to the ground, more irregularities appear. Similarly, this paper looks at stock market dependence from a closer viewpoint in order to check for statistical dependence during shorter time periods. Since economic events are hypothesized to be a source of market dependence, three differ-

ent time periods are studied in detail. The 1971-1974 period is studied because of the first oil price shocks. The 1978-1981 period is included because of the second series of oil price shocks, and the 1986-1989 period is examined because of the stock market crash in October 1987. In order to study the change in behavior of the markets during different time periods, a cross-sectional autocorrelation coefcient is computed. Unlike other measures of dependence, this measure is free from prob-

lems caused by nonstationary processes. The paper is organized as follows. The section
provides a review of the literature and a statement of the problem. Next, the methodology and a description of the data sets is presented. The empirical results for 1971-1974, 1978-1981, and 1986-1989 are presented in three sections, while the next two sections examine monthly data from 1926 to 1992 for the S&P500 market index and regression results from 1960 to 1992. Finally, concluding remarks summarize the results of this Paper. Review of the Literature A simple random walk return model can be stated as follows: Ra) = ea) (1) where is the mean of the process with errors e distributed randomly over time t. This is a simple stationary equilibrium model of security returns. However, returns

Market Dependence and Economic Events 289

very likely follow a more complex process. Groth [19] de-

scribes the return process as a two-step process: First, there is the information market that generates the arrival of information flows, and second there is the pricing mechanism that disseminates information in order for the appropriate price to be determined. The information arrival process is expected to operaize according to the information theory developed by Sharmon [42], Weiner [48] and Shannon and Weaver [43]. Under the information theory, the information content of a message is related to the amount of surprise contained in the message. This means that information is independent over time and that if we can predict the occurrence of an event, then when the message is received, the event has occurred, and there is no information content to the message. When new information (surprise) arrives, then the mean return has to change reflecting the new information. While Groth [19] does not use the formal information theory model, his paper is in agreement with the information theory as it draws a distinction between data and informatin; i.e., data which affect price when processed by the pricing mechanism are considered as information and data received at the pricing mechanism that do not affect price are not defned as information. Since information arrives in discrete batches at discrete points in time, then the resulting mean process has to be a mean-jump process (Poisson and Bernoulli jump processes are the most commonly suggested processes). Tiie mean-jump process has received empirical support from Vlaar and Palm [47], Tucker [46], orion [23], Ball and Torous [4] and Oldfield, Rogalski and Jarrow [37]. In addition, Akgiray and Booth [1] and Lau, Lau and Wingender [26] provide evidence that stock market returns cannot be described using stable probability distributions with stationary means. The pricing mechanism disseminates and assimilates informatico and can be modeled as an adaptive-reactive control process. Murphy [30] and Copeland [14] both model the pricing mechanism as a process that reacts to the sequential information
dissemination process. Informa-

tion arrives sequentially due to frictions in the marketCopyright@ 2001 _ All Rights Reseved.

290 Nawrocki

place. Groth [19] argues that all markets do not have the same ability to assimilate information due

to information costs. Larger markets can afford more security analysts, etc., than can smaller ones. Therefore, smaller markets will be informationally less efcient. Morse [29] argues that the amount of information is also important. An arrival of a large amount of information will trigger more analysis and trades. Therefore, the speed of information dissemination will be nite and Will vary with the amount of new information. With large amounts of new information, the markets will not react as quickly as with small amounts of information. To support this argument, Morses empirical study dis-

covers signicant serial dependence during periods of increased trading volume. Nawrocki [32] argues that a market under these conditions will exhibit an error process with nonstationary
autocovariance function be-

cause of the varying information assimilation eficiency. This argument is supported by Chans [10] study which demonstrates positive cross-autocorrelation between stocks because of nonsynchronous
trading. Trading in large stocks with better information systems will lead to trading in smaller stocks with poorer information systems. In addition, the cross-autocorrelations vary with the size of market movements which indicates a nonstationary autocovariance function. Thus, the return process can be modeled in the following way, as found in Nawrocki [32]: RU) = (2) where is a mean jump process (nonstationary mean) and is a nonstationary autocovariance matrix. The nonstationary mean and nonstationary autocovariance processes vary over time in direct response to the amount of new information arriving into the market and to the varying finite speed of information dissemination. The information process, I(t), is hypothesized to be a sequential information arrival process following a sporadic jump process. The information jump process is the source of the nonstationarity that drives the mean-jump process. Market frictions and rigidities prevent the

Market Dependence and Economic Events 291

immediate dissemination of information, resulting in the nonstationary autocovariance process. Other

explanations for the nonstationary autocovariance process exist in the literature. One explanation is the competence-difculty gap hypothesized by Heiner [21] and supported by Kaen and Rosenman [24]. The greater the spread between the competence of investors and the complexity of the information, the greater the increase in market dependence. Guth and Philippatos [20] suggest that the lack of common knowledge beliefs by investors causes increased volatility When new information arrives. In addition, Peters [38,39] suggests that new information affects how investors interpret the effect of the new information over different investment horizons. Different horizons will provide different expectations leading to large changes in price until the pricing stabilizes as the new information disseminates.

Recently, there is additional evidence that stock market volatility is time-varying (e.g., French, Schwert, and Stambaugh [17]) but predictable (e.g., Schwert and Seguin [41]). A number of papers describe this process as an autoregressive conditional heteroskedasticity process using ARCH models (e.g., Bollerslev [6] and Nelson [34]). Hsieh [22], in particular, ascribes stock returns to
condi-

tional heteroskedasticity models using a more flexible EGARCH approach. The problem with the ARCH, GARCH, and EGARCH approaches is either the conditional (nonstationary) mean changes or the nonstationary autocovariance process are ignored. Current studies either allow for nonstationary meanjump process and a stationary EGARCH process (Vlaar and Palm [47]) or a nonstationary
EGARCH/IGARCH process with a station-

ary conditional mean (Lamoureux and Lastrapes [25]). Ignoring a nonstationary mean is dangerous. Booth, Kaen and Koveos [7] long-term dependence in gold prices using rescaled range
(R/S) analysis but are concerned with a short-term transient that may have been caused by the events in Iran and the Hunt brothers attempted corner of the silver market in November and December 1979. In a later paper, Aydogan and Booth [3] warn that R/S analysis is biased by nonstationary means. Because
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292 Nawrocki

of short-term dependence effects on the R/S statistic, Lo [27] develops an R/S statistic that corrects

for short-term autocovariance. However, Cheung [11] tests the Lo [27] statistic using Monte Carlo simulation and finds that it is very sensitive to nonstationary means, while at the same time it is robust to nonnormal distributions and nonstationary variance (conditional heteroskedasticity). Given this result, Cheung and Lai [12] restudy gold prices. Using a rolling sample approach and by eliminating observations from November and December 1979, the Lo [27] statistic detects significant longterm dependence when the 1979 data are included. When the 1979 data are excluded, the Lo statistic detects no dependence, thus demonstrating the effect of nonstationary means on the study of long-run dependence. Nawrocki [33] uses the Lo [27] statistic to demonstrate nonstationary mean behavior that derives from the general economic cycle. With both the mean and error process exhibiting nonstationary behavior, studies of the stock market have to concentrate on structural changes in the market or on significant economic events. This implies that studies have to use new statistical methods to extract more information from a given time series in order to detect structural changes in the market. With this in mind, this study focuses on three periods of market instability and structural change during the past twenty years: 1971-1974, 1977-1981, and 1986-1989.

Data and Methodology

A number of data sets were used to study market behavior. Data sets of relative returns were obtained from the monthly and daily CRSP data tapes. First, there was a random selection of 125 stocks with daily data for each of the three periods and the CRSP ValueWeighted and the S&P500 Composite Indexes as well. In addition, there was a random selection of 117 stocks with monthly data from the 1960-1992 period and the monthly S&P 500 Composite Index from 1926 to 1992. The statistical methodology used in this study derives from statistical control theory. Murphy [30] is the rst researcher to model the sequential information
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Market Dependence and Economic Events 293

dissemination process as an adaptive control process. This model derives directly from the work

in cybernetic systems by Weiner [48]. The control process evaluates the sequential arrival of information as it disseminates through the market. Murphy uses the conditional entropy (a statistical measure from information theory) of the process to indicate the amount of undisseminated information in the system. When the conditional entropy measure is maximized, then all information is disseminated. Therefore, a control process Where the conditional entropy is maximized at all times would be a random walk and would be a perfectly efficient market (Cozzolino and Zahner [15]). Since there is undisseminated information because of friction in the sequential information process, Murphy defines a statistical equilibrium as whenever the conditional entropy falls within a stable statistical boundary below the maximum entropy level. This is the typical definition of a process in control in standard statistical control theory. The conditional entropy is a nonparametric information theory measure of serial dependence, therefore, a more commonly used measure such as autocorrelation may also be used as a proxy for undisseminated information. The problem with a statistical equilibrium in a control process is detailed in Alwan and Roberts [2], i.e., the problem of using cumulative sums (sequential stable means and conditional standard deviations) to determine whether a process is in statistical control. The process could seem to be in control and not be in actual control because the underlying process is nonstationary. If the underlying process is nonstationary (Which is the expected case with security returns), then the statistical control limits should be based on marginal standard deviations not conditional standard deviations. However, any concern about the control limits diverts attention from the true problem: that the conditional mean is constantly changing. Therefore, the control limits have to be based on marginal standard deviations computed around moving averages. Chowdhury and Lin [13] and Cheung and Lai [12] both demonstrate that special events that create statistical outliers will cause statistical biases in longer term measures of serial dependence.
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The solution is to use as short of a moving average period as possible in order that outliers will not bias serial dependence values calculated in other

periods. One method to achieve the number of observations needed for proper statistical estimation of a
moving average and to maintain a short time period is to use cross-

sectional analysis, whch is commonly used in statistical control theory. In process analysis, control
charts for dis-

persion are developed to determine Whether a process is in control or not, to estimate the parameters of the system, and to detect when control is not achieved (Cryer and Miller [16]). Instead of cross-sectional dispersion, this study is interested in cross-sectional dependence or the crosssectiona1 autocorrelation coefficient (CSAC). The cross-sectional statistic is one approach to studying economic systems such as the control processes suggested by Murphy [30] to describe economic
market processes as adaptive control processes. These processes are nonstationary in nature and require statistical measures that are free of biases caused by nonstationarity.

Using relative percentage returns, the cross-sectional autocorrelation coefficient can be calculated as the correlation of returns for securities for the current period and for a one period lag. The CSAC is simply the correlation for each period t, or where i = 1, 2, ...,n securities Where n is also the number of observations used in the calculation of the coefficient. Each pair of observations used in the calculation of the CSAC involves returns from only one security, therefore the order of securities in the
sample does not affect the calculation. Cross-sectional autocorrelations are calculated for both the daily and monthly security samples and represent an equally weighted index of market dependence for a particular data period. The is used to test for significant autocorrelation. The 1971-1974 Period The Economic Events The two major economic events during this period were President Nixons announcement of wage-price

Market Dependence and Economic Events 295

controls on August 15, 1971 and the Arab-Israeli Octo-

ber War in 1973. As a result of the October war, the Arab countries announced an oil embargo on October 17, 1973, followed by Saudi Arabias announcement on October 19, 1973 that they were slashing oil production by 25 percent. Because of oil already in the
distribution channels, the oil embargo did not impact the United States until the rst quarter 1974, when there were widespread gasoline shortages. (Sources of the historic information include Adam Smith [44], Stobaugh and Yergin [45] and the Citibase/Fame database.)

Autocorrelation Results for the CRSP Value Weighted Index

The daily autocorrelation with a lag is 0.2914 9.6604) for the 1,009 days during this period. One of the many problems with autocorrelation analysis is the averaging effect of a large number of observations. Because of previous literature cited in this paper, it is very likely that the temporal dependence relationships in the market are constantly changing. One way to overcome this problem is to study shorter Subperiods. This is shown in Table 1, which provides cross-sectional autocorrelations (CSAC) during the period of President Nixons announcement of wageprice controls in 1971.

President Nixons Announcement of Wage-Price Controls The interesting observation in Table 1 is that there is signicant CSAC on the Friday before Nixons
an-

nouncement and on the Monday after the announcement. More interesting is the suggestion by Ney [35] that price manipulations by the market
specialists prevented the market from moving appropriately during these periods. In two books in the early 1970s, Ney [35,36] provides evidence that the specialist system was not maintaining the proper pricing mechanism on the N.Y.S.E. To examine this period, the 125-stock universe

(selected
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296 TABLE 1

Market Behavior During and After Nixons Announcement of Wage Price Controls (August 15, 1971) Volume in 1000s Specialists Total lo Market Date Volume Purchases Sales Shorts CSAC T-Test %Return 1298 1470 1443 2181 1384 1157 1386 1853 2820 1464 Sunday-Nxons Announcement 31731 26794 20676 14190 11900 5111 4367 3547 2470 1997 8001 4169 3003 2058 1702 0.0007 0.1393 0.0036 0.0838 0.1228 0.0770 0.0721 0.0815 0.1237 0.1287 0.0293 0.2250 0,0340 percent significance. **10 percent significance-One Tail test. Statistical Source: Pindyck and Rubinfeld [40]. The trading volume and specialists purchases, sales and shorts are from Ney [36]. Additional information in this paper concerning the events, dates and economic data comes from sources: Citibase Database, Ney [36], Stobaugh and Yergin [45], Smith [44], and Moore [28]. CSAC-Cross-Sectiona1 Autocorrelation

from the N.Y.S.E.) is used to study the day-to-day changes in dependence. A cross-sectional serial correlation is computed for each day, which avoids the averaging effect of the longer time periods. Table 1 provides additional data from Ney [36] and the daily autocorrelation coefficients during the period when Nixon announced the wage-price controls. Table 2 provides the cross-sectional autocorrelation for monthly data using 117 stocks. Ney [36] charges that the Nixon administration leaked information about the new policy to the exchange