Can Macroeconomic factors predict stock market returns? A case of listed financial stocks on the Dhaka Stock Exchange

The problem

There has been a lot of research using macroeconomic factors to predict overall stock market returns, but very few research papers have attempted to predict stock returns on a sectors basis. This paper aims to find if some of the macroeconomic variables may help to predict stock market returns of listed financial stocks on the Dhaka Stock Exchange. The financial stocks will be divided into two categories, banks and insurance companies.

Review of the Literature

Bank Stock Returns in Responding the Contribution of Fundamental and Macroeconomic Effects

This study has attempted to find if there is any relationship between several microeconomic factors using the CAMELS ratios and several macroeconomic factors like interest rate, exchange rate, and inflation rate with the stock returns of 16 listed Indonesian banks. The study found evidence that all the three macroeconomic variables negatively and significantly contribute to the stock returns of the 16 banks for the period 2002 to 2011. The research paper has used the Pooled Least Square Model to carry out teh test.

Effect of Macroeconomic Variables on Stock Returns of Listed Commercial Banks in Kenya

The study uses quarterly time series data from 200 to 2015 to explore if there is a relationship between stock returns and macroeconomic variables on listed banks in the Nairobi Stock Exchange. The variables used are exchange rate, inflation rate, interest rate and GDP. A linear regression model using Ordinary Least Squares was used. The paper concludes that all variables except GDP had a significant effect at the 5% level of significance.

Macroeconomic Determinants of Stock Market Development

This paper uses data for 15 countries for the period 1980 to 1995. The countries include seven countries in Lation America, Six in East Asia, and two advanced economies: US and Japan. The paper explores the effects of real income, saving rate, financial intermediary development, stock market liquidity, and macroeconomic stability on stock market capitalization. The authors use regression and conclude that real income level, savings rate, financial intermediary development, and stock market liquidity are important predictors of market capitalization.

Research Questions

I intend to use monthly macroeconomic data for Bangladesh and monthly market cap data for banks and insurance companies listed on the Dhaka Stock Exchange to answer the following questions.

  1. Are there macroeconomic variables that can help predict the stock returns of the banks listed on the Dhaka Stock Exchange?

  2. Are there macroeconomic variables that can help predict the stock returns of the insurance companies listed on the Dhaka Stock Exchange?

Data

Data available is very limited since we are using monthly data. Data will be collected from the Bangladesh Bank website and CEIC. Monthly GDP rates are not available and therefore we will need to take a proxy for that. Most of the data are also available on YoY percentage change format and will need some transformations.

Variables

Some of the variables of interest are interest rates on different Tbills and bonds with different tenures, inflation rates, industrial production levels, Monet supply measures including M1 and M2, Domestic credit, Foreign Exchange reserves, Remittances and PE ratios of the overall stock market.

Tools

We will be using R and its packages to clean the data and do predictive modeling. We will be using Linear Regression models inclusing, Partial Least Squares, Principal Component Regression, and if possible penalized models like Ridge, Lasso and Elastic net to explore which method is best at predicting the stock returns. If data permits, non linear models like kNN, SVM, MARS and Neural Network models will be tested.The same process will be followed separately for bank and insurance companies. Models will be evaluated using metrics such as adjusted r squared, accuracy, MAPE, and RMSE.