Study: Equity Index Allows Forecasting the Economic Outlook for Latvia

30.03.2010 RIG

A study initiated by NASDAQ OMX Riga identifies the relationship between the movements of OMX Riga, a price index of the companies listed on the Latvian equity market, and the Latvian GDP developments two quarters later. Leading indicators such as equity indices and sentiment indices are commonly used in the US and other economies with developed capital markets; however, up to now it was not known whether this correlation holds true for the Latvian market. This is the first-ever research on the applicability of a stock market index in forecasting economic growth in the Baltics.
 

The Latvian stock market index leads GDP by six months

The study results reveal that in Latvia, like in developed economies, there is a number of leading indicators. In Latvia, they lead macroeconomic indicators by a quarter or two. The movements of an equity index can be used to forecast economic trends in Latvia half a year in advance. Though an upswing in the equity market does not necessarily guarantee economic growth, but there is a 75% probability it will coincide with GDP results two quarters later.

„In the Baltic economies, the highest correlation is between the movements of equity indices and the GDP data in the following quarter. In Latvia, the correlation tends to be somewhat stronger between NASDAQ OMX Riga equity index and GDP two quarters later (59%), while the correlation between the equity index and GDP in the next quarter stands at 55%. This allows us to conclude that the Latvian stock market prices the economic growth anticipated about six months later. Statistical tests provide medium-strong evidence to this conclusion,” explains Jānis Praņēvičs, author of the study and Senior Analyst of Parex Asset Management.
 

The government should further develop the Latvian capital market

Daiga Auziņa-Melalksne, NASDAQ OMX Riga Chairman of the Management Board, points out: „A high-quality stock exchange index is an important indicator for international investors while making their decisions about investing in a market. This is why it is paramount to further develop the Latvian capital market and equity index, as well as increase the number of listed and index companies to include telecommunications, transport, energy and other sectors. Companies need investment, and listing on the stock exchange gives them access to funds contributed by financial investors. It is natural that the equity index is the first to offer insight in future economic trends, because, owing to disclosure, listed companies have a high level of transparency: they are required to inform investors and media on any significant events, and their financial statements are made publicly available in Latvian and English on a quarterly basis. A developed capital market has a high potential for raising foreign investment and facilitating balanced economic growth, therefore the government should support its development to the extent possible.”

Equity index as a benchmark for global rating agencies

The fact that the correlation is true for the Baltic market is of great importance, suggesting that the Latvian stock market and its equity index is guided by the same principles as in economies with well-developed capital markets. It is a factor that boosts foreign investors’ confidence in and reliance on the investment environment in Latvia. „Global rating agencies pay close attention to the equity markets and consider their performance when assessing the state of an economy. For example, in autumn 2009 when Latvia’s economy was in a state of weak stabilization at best, Moody’s noted that the domestic stock market is already displaying positive signs,” the author of the study adds.

Equity index differences from other indicators

An equity index has a high value when it is necessary to forecast economic sentiment, because it is based not only on individual opinion, but the actions performed by a number of professional investors, investing in company shares. In contrast with market sentiment surveys, stock market investors make financial decisions, take risks and “vote” with real money. The stock market offers direct and generous returns to those who are the most proficient and fastest in foreseeing changes in economic sentiment and the financial performance of listed companies. When investing and risking their own money, investors pay attention to the smallest detail that is relevant to developments in a company and thereby can affect its financial results. This is the reason why future economic developments and trends are noticed of at a very early stage in the stock market and already priced in share buy or sell quotes before any official data are released. An equity index reflects price changes for a variety of shares.

Equity index importance for investors

Leading indicators such as equity indices and a variety of sentiment indices have a large practical significance, since the ability to forecast economic developments is important for any company and business owner. Leading indicators increase confidence in a predictable business environment, help plan cash flow and make decisions about further investment and other business areas. In developed economies, e.g. the USA, the correlation is stronger and extensively used by economists and investors as well as company managers and chief financial officers.
 

Research paper (full text, in Latvian)