Macroeconomic forces and stock prices: Some empirical evidence from an emerging stock market

This paper examines the causal relationships among stock prices and macroeconomic variables in an emerging stock market, the Colombo Stock Exchange (CSE). We use data on six macroeconomic variables and All share Price Index (ASPI) of the CSE for the period January 1985 to December 2004. In the empirical analysis, we employed recently developed root tests that possess better power and size properties than widely-used Dickey-Fuller type unit root tests. Johansen's test, Error-correction models, variance decomposition and impulse response analyses indicate that there are both short and long-run causal relationships among stock prices and macroeconomic variables in Sri Lanka. These results indicate that stock prices can be predicted from certain macroeconomic variables and hence violate the validity of the semi-strong version of the efficient market hypothesis. The above results have implications for investors, both domestic and international.