The permanent-transitory decomposition of the stock markets of the G7 countries: A multivariate approach

This paper tests for the presence of common stochastic trends and cycles in the stock prices of the G7 countries. It further uses the existing common trends and cycles to provide a parsimonious decomposition of the stock prices into their permanent and transitory components, using the method of (Proetti, T. (1997). Short-run dynamics in cointegrated systems. Oxford Bulletin of Economics and Statistics, 59, 405–422) and (Hecq, A., Palm, F.C., & Urbain, P. (2000). Permanent-transitory decomposition in VAR models with cointegration and common cycles. Oxford Bulletin of Economics and Statistics, 62.4, 511–532). Finally, we offer some tentative evidence on the determinants of the permanent and transitory components of the G7 stock prices. Our evidence explains the trends in terms of fundamentals and cycles in terms of psychological factors, with interesting possible implications for international portfolio management.