Common trends and common cycles in stock markets

•We examine the role of permanent and transitory shocks.•We consider the S&P 500, Dow Jones and the NASDAQ markets.•We find one common trend and two common cycles.•Permanent shocks explain the bulk of the variations in stock prices.

In this paper we examine the role of permanent and transitory shocks in explaining variations in the S&P 500, Dow Jones and the NASDAQ. Our modeling technique involves imposing both common trend and common cycle restrictions in extracting the variance decomposition of shocks. We find that: (1) the three stock price indices are characterized by a common trend and common cycle relationship; and (2) permanent shocks explain the bulk of the variations in stock prices over short horizons.