The difference between Stock market and the Economy

 

The stock market is often used as a gauge of the economy, both by news agencies and world leaders. when stocks are up, it's viewed as a positive signal, With many politicians celebrating growth in the market as evidence. They're doing a bang-up job helping the economy move forward for the most part. 

The claim isn't terribly off-base as you can see over the long term, the two have broadly moved in line with one another. Yet recently we saw a fundamental divergence between these two entities. Despite countries undergoing the worst economic contraction in a decade, the stock market rose throughout much of 2020 at least in the US. In fact, at the same time central banks were warning us of further decline unless we see further government intervention. 

The s&p 500 a popular U.S index surpassed its pre-pandemic level actually hitting an all-time new high in september. So what gives well? Well it might appear paradoxical. The truth is that the stock market and the economy don't actually measure the same thing. The two concepts are certainly closely connected, however, there are fundamental and substantial differences in what they represent and while an investor may breathe a sigh of relief when stocks rise, be warned it's not as strong a sign of good times ahead as you might expect.

 So what separates the stock market from the economy? and how should investors interpret the two. we'll answer these questions and more in this post. 

 The stock market broadly references the collection of markets and exchanges such as, the nasdaq, the tsx or the lse in europe, where stocks are bought, sold and traded. The market is considered up, when the value of assets being traded on exchanges are trading upwards and down when stock prices have moved lower. To track these movements analysts often use indices. A measure that averages the stock prices of a sample of stocks, that are deemed representative of a particular population whether it be a country or a sector. And while different stocks may move in different directions, indices give us a gauge of how the market as a whole is moving on a given day.

 The economy on the other hand is a much broader measure, that takes into account the entirety of goods and services a society or country produces not just the market value of public companies. It is often measured through gross domestic product or GDP, which is equal to the value of all goods and services consumed, plus government spending investments and net exports. however economy is also gauged through a number of other measures, including but certainly not limited to unemployment, inflation housing starts and many other measures.

 This brings us to the first difference between the stock market and the economy. the scope of the objects. While the stock market provides an accessible and convenient gauge of the economy, it only provides us information on companies listed on the stock exchanges. the public companies. This naturally provides a skewed view of the economy. While the bagel shop on the corner of your street might not be included in the calculation of a stock index, its output, the people it employs and the taxes it pays all feed into the wider economy. Those bagel shops are important too and i'm not just saying that out of bias. 

33.4 percent of workers in the US are employed by companies with fewer than 100 employees. And roughly two-thirds of us employment in the non-farm business sector comes from private companies. 

As you can see the economy's wider lens means its measurements are usually more applicable to the general population. while most people are employed, not everyone has money in the stock market. So while an economic recession may lead to layoffs and lower disposable income, which therefore accelerates the decline in the market. A decline in the stock market might not have a direct impact on the finances of your average joe.

 Now that's not to say the stock market is not important. Stocks have indirect impacts on the economy and individual prospects, which is why many still consider it when trying to gauge how the economy is doing.

 For example: imagine you're employed at a young company, that's issuing shares to fund growth projects and after a stock market crash its stock price is reduced to pennies. suddenly that company can't raise enough money to fund its growth plans on the public markets. As a result it will likely cancel projects, lay off employees and in the worst of circumstances shutter its operations.

 A decline in the stock market can also impact the economy, by hurting the wealth of those who are invested in it. Not only may investors be spooked out of providing money to companies during a decline, but the hurt to their investment portfolio may lead them to consume less. Perhaps putting off that home renovation or car purchase until after things have recovered. A strong stock market meanwhile can have the opposite effect on the economy. When stocks are up companies may have more confidence to invest in hiring employees, finding themselves able to raise more capital.

 On the public markets the wealth effect can also come into play. Here this refers to the phenomenon that: a higher stock rises, the more those invested in it are likely to spend themselves. Which in turn can boost the economy win win. By now you're probably noticing the many correlations between the stock market and the broader economy.

 A strong stock market can boost the economy while a weak market can naturally impair it and precipitate economic downturns. And it's not just a one-way relationship. The stock market is heavily influenced by the wider economy. Investors and analysts are constantly making their buy and sell decisions based on their observations in the economy. Taking into account factors such as interest rates, fiscal policy employment, housing starts, so on and so forth.

 That's why you can see the massive shifts like we saw on october 6th 2020, when the dow swung 600 points. After it was announced that there might be a delay to the stimulus bill related to the novel coronavirus pandemic until after the election. On top of this economic hardships can clearly impact a company's operations. Something that may lower its stock price as investors factor in this higher risk. But, if these two entities are so interrelated like what we've explained, then why can they diverge so drastically?

 Sure the stock market may not be the best gauge of the economy, but the two should still move in the same direction. right? Well that comes down primarily to the second difference between these two concepts. The stock market and the economy focus on different periods of time.

 

The stock market is a forward-looking measure. Investors buy and sell stocks based on what they think will happen not what's already occurred in the past. In other words the stock market will tend to rise, if there's a strong belief among investors that tomorrow will be better than it was today.

 

The economy meanwhile tends to look backwards. Some of the main indicators that we use to gauge the economy, housing prices, unemployment, spending, inflation, are usually reported with a lag. So when we talk about current levels of unemployment, we're actually talking about how many people were gaining or losing jobs last month. Data that by its very nature is already out of date. So even if the economy seems to be in a funk, say with high unemployment due to a recession, the stock market might be on the rise if investors see an upswing on the horizon. 

Good news for times such as these. right? Well, not exactly. While stock prices reflect investor expectations, the future may or may not turn out as anticipated. you need not look further than the 2000.com crash for an example of high hopes being shot down by harsher economic realities. Muddying the waters further, is the fact that the stock market doesn't actually have a single objective measure. Sure while indices such as the s p 500 are commonly used to gauge stock performance, it applies but one of many approaches to calculating its level. Specifically the s p 500 is a market cap weighted index. meaning it gives more weight to larger firms in its calculation and while this is a reasonable approach, it means the stellar performance of a few large cap companies can outshine the underperformance of smaller firms, even if the net impact on the wider economy is negative. 

So faced with a not so straightforward forward-looking stock market and the lagging indicators of the economy, what's an investor to do? Well the answer as usual is the balanced approach. The stock market and the economy are in a constant state of influencing one another, giving dueling interpretations of investor confidence and economic realities. What's important though is to take both measures with a grain of salt.

 The stock market and the economy are naturally pretty complicated entities and there's no single measure or figure that perfectly sums up how things are going. So it's important to recognize and consider the shortcomings of any figure or stat you read about in the news. especially, when you're using it to justify an investment decision. That's not to say there's no value in trying to gauge where the economy is. 

Eventually stock prices do adjust to reflect economic information, but the two are far from being synonymous with one another. They're more like distant relatives that see each other once a year at a thanksgiving dinner and with the current pandemic perhaps it'll be a little longer still before the two properly reconcile.

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