Stock market fluctuations and the business cycle

This paper explores the dynamic relationship between stock market fluctuations and the business cycle. Presumably, stock market movements reflect positions taken by market participants based on their assessment about the current state of the economy. Given the forward-looking behavior of stock market investors, this paper explores the possibility of predicting business cycle turning points using promptly available financial variables. Stock market fluctuations and business cycles are represented by nonlinear dynamic factors at the monthly frequency. The proposed model generates predictions of business cycle turning points using the business cycle factor, and anticipation of these predicted turns using the stock market factor. The findings indicate that the extracted stock market factor is a leading indicator of the state of the business cycle and can be used to anticipate turning points in real time.