Introduction to the Stock Market Part III. The Stock Market and the Economy
Understanding both the stock market and the economy more fully will also help you make better, more informed investment and economic decisions.
By Kaitlin Meyer — April 19, 2023
The economy is something that affects each of us in our everyday lives. The stock market is closely related to the economy, and understanding how the ups and downs of the stock market influence the economy can help you interpret different financial and political information. Understanding both the stock market and the economy more fully will also help you make better, more informed investment and economic decisions.
Are the Stock Market and the Economy really that closely related?
Because a few wealthy Americans own most stocks, it is sometimes perceived and argued that the stock market could not really have that much influence over the economy or the average American. While this is true, many average American households invest in the stock market in some capacity. You are invested in the stock market if you have a retirement account through your employer (usually a 401(k)). As an individual, you will feel more financially stable when the stock market is doing well, and your investments grow.
In addition, the stock market consists of stocks from companies. These companies are essential to our way of life as Americans: they provide us with power, groceries, and countless other goods and services that we rely on daily. Companies depend on the stock market to raise the capital needed to expand their businesses.
The Relationship between the Stock Market and the Economy
The relationship between the stock market and the economy goes two ways: it is symbiotic. The economy represents the wealth and resources of a country, usually determined by the production and commerce of goods and services. Practically, gross domestic product, otherwise known as GDP, measures how well or poorly an economy is doing. To understand the relationship between the economy and the stock market, it is necessary to understand their different natures. Stock market prices represent investors' and market makers' predictions of how well or poorly certain companies will do. Thus, the stock market is fundamentally ordered toward the future. The economy, on the other hand, reports the current state of the economy. Due to the inevitable lag between the true, current state of the economy and the reported GDP, the economy is fundamentally ordered towards the past.
Because of the different natures of the economy and the stock market, the relationship between the two is very complex. For example, since the stock market is forward-looking, it often leads to economic cycles. This means that the stock market might bottom out and begin to recover before a recession and boom before the economy reaches its peak. For this reason, the stock market can be an early indicator of a recession. To understand why this might be the case, let's look at what drives GDP: consumer spending, business spending, government spending, and exports. The direction of the stock market can influence each of these four variables. When there is a strong correlation between these variables and the stock market, the economy may follow a similar trend as the stock market. However, this does not always happen, as several other factors affect spending and export.
The stock market's forward-looking nature does not mean it is unaffected by the economy. For example, share sales are highly correlated to government reports on current inflation and employment statistics.
Feedback Loops
Another interaction between the stock market and the economy is how investors react to economic news. Investors who hear that the economy is doing well might be encouraged to invest more, causing the stock market to upturn. Investments can also downturn when investors hear bad economic news. This relationship is one feedback loop contributing to economic downturns and even a recession. For example, investors may see a stock decreasing in value and become concerned that it is risky. Perceived risk might cause them to sell any of these stocks they currently have in their portfolio, causing stocks to decrease further in value. Thus, other investors may follow suit and sell their stocks. This cycle can continue until that particular stock crashes. This pattern does not have to happen with one particular stock or company. It could happen in an entire sector or, in extreme cases, for the entire stock market. While cycles like these have been observed, the stock market and the economy do not always follow the same trends, especially over shorter periods.
There is a lot more to the complex relationship between the stock market and the economy, but this article briefly introduces the topic. As you can see, the two are closely related, and fluctuations in the stock market affect individuals and their investments as well as public companies.
Kaitlin Meyer
Kaitlin Meyer is a Master's student at Ohio State University (OSU), and is writing a thesis on snow microstructure inspired by her love for skiing. She earned a B.A. in Liberal Arts from Wyoming Catholic College (WCC).
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