Production-Based Asset Pricing and Economic Tracking Portfolios : Establishing a Dynamic Partial Equilibrium Link between Economic State and Investment Levels

This paper investigates the link between economic state and investment levels in an economy within the premise of a partial equilibrium econometric setup based on the central philosophies of production-based asset pricing model and economic tracking portfolio models. By employing a simple linear combination of a functional transformation of an exhaustive set of economic variables, constituting both broad based macro-variables and variables associated with explicitly identified sectors of the economy, as a model to define an economic state reflecting the available information at any point in time, the paper employs a series of cointegration regression models to establish a dynamic partial equilibrium link between stock market index levels and a dynamically changing/evolving economic state with a one-period lag. A similar dynamic partial equilibrium link, in the spirit of economic tracking portfolio models, is established between sector based indices, constituting the broad market index, and the corresponding economic state model for each of these sectors that take into account explicit economic variables representing these sectors, also with a one-period lag. Finally, the paper extends this framework to establish a similar relationship between economic state and aggregate and sector-based venture capital investment levels, linking the central ideas behind production based asset pricing models and economic tracking portfolio models. The stability of each of these models is investigated by making out-of-sample forecasts and calculating the average time needed for re-evaluation of the models and the recalculation of the associated parameters, before the quality of such forecasts suffer, because of a change in the evolving economic state and effects of such a change on the investment levels in an economy