The stock market is often used as an economic indicator to determine the current economic conditions. Due to this relationship, we often believe that when the markets are good, the financial health of society is too.
Let’s take this popular belief and take it apart to understand the relationship. Discover the real effect that the stock market and the economy have on one another.
Understanding the Stock market and Economy
To talk about the stock market and economy, it is important to understand what the two are. So let’s define these two forces in greater detail.
What is the Stock Market and how does it work?
The stock market is the marketplace where investors can buy and sell stocks. A group of stocks selected to represent the overall performance of a market is called an index.
The S&P 500 is an example of one of these indexes that are often discussed. 500 large companies make up this index that trades on U.S. exchanges.
Well-known companies that operate on a global scale, such as Amazon, Starbucks, Google, and Facebook, make up the S&P 500. The performance of this index is considered representative of the whole U.S. equity market.
What is the Economy and how does it work?
The economy is the collective activities that go into making and spending money in a country or region. The economy is measured and tracked through the Gross Domestic Product (GDP).
A negative GDP for two consecutive quarters is considered a recession. If the economy continues to have several quarters of negative growth, that is considered a depression.
Other indicators used to measure the economy include employment levels, consumer confidence, spending, and the housing market.
How does the Stock Market Affect the Economy?
The stock market affects the economy in several important ways. It allows anyone to have access to investing in the stock market, can help investors/savers with inflation, and fund business growth. Let’s discuss these three stock market impacts in greater detail.
Enables Investors of any Size to Invest in the Stock Market
The individual investor can buy stocks in the stock market, regardless of how much money they have to invest. Large, private equity investors and financial institutions would be the only investors that could access the market economy if the stock market did not exist.
Allowing access to investing to small investors provides the opportunity to build their wealth. Individual investors with less wealth gain the ability to invest with publicly traded companies like Disney, Google, and Amazon.
Help Combat Inflation
The stock market is a great hedge against inflation. Savers and investors who invest in the stock market over time can win despite poor market conditions.
The average amount that a prices increase in stock markets is 7%, after accounting for inflation. That’s a better rate of earning than other options like putting money into a savings account.
Fund Business Growth Opportunities
For a company to grow, it must have funds to help them in these endeavors. That’s what makes the stock market important
It offers a source for a company to raise money. For example, the owners of a company may decide to offer an initial public offering (IPO) and sell part of the company through shares.
Going public allows companies to raise a lot of cash and demonstrates to other investors that the company is successful. The potential negative impact of selling stocks of its company is that the founders no longer own it.
The shareholders become the owners of the company. One way that founders can retain controlling interest in the company is by keeping 51% of the total stock.
How does the Stock Market Affect GDP?
The U.S. economy’s GDP is what drives spending and investment. Let’s look at an example of how GDP works to understand its relationship with the stock market.
As mentioned, GDP is typically expressed as a percentage growth rate from the last period. So that means if the quarter-to-quarter growth rate was 2%, the U.S. economy grew by 2% in that quarter.
The GDP is made up of several components, including:
- Consumer spending – Total money that individuals and households spend on final goods and services for personal use
- Business spending – Includes purchases of new equipment, hiring, new buildings/offices, and investments in technology
- Government Spending – Includes new building expenditures like roads, bridges, and subsidies
- Exports – Sales that domestic companies make to international customers
These factors could be influenced by investors through the stock markets.
A bull market occurs in the stock market when the markets rise. When stock prices rise, there is a general sense of optimism about the economy.
The stock market’s influence on the GDP is primarily related to its effect on consumer confidence and financial conditions. Generally speaking, it is easier for a company to issue new shares to raise capital that can be used for new projects, more workers, expanding operations, and other activities.
There is economic growth if the GDP is rising, which also means that these companies can also raise funds by borrowing money from banks or issuing new debt, which is called bonds. Investors buy these bonds, which are turned around and used as a business investment to expand and grow, which also increases GDP.
Consumer and investor optimism is high in these conditions. Good economic health makes people feel secure, and they likely have more money.
The wealth effect has a profound impact on people’s spending, which tends to increase in these conditions. Consumers will make big purchases like cars and homes. The GDP gets boosted from these sales, as do companies.
In a bear market, stock prices are falling, which has a negative effect on consumer and business confidence. The major reason that the stock market falls is that investors sell their stock to prevent losses.
The decrease in investing also tends to lead to lower consumer spending. When consumers don’t spend money, that leads to a reduction in corporate profits, sales, and revenue.
This leads to companies cutting costs and workers. The overall economy becomes less certain and unemployment increases.
Another significant impact for businesses is that it becomes more difficult to acquire financing. A company may find it more challenging to manage its existing debt with less money coming in.
Investing during a Down Economy or Volatile Market
A stock market crash or recession is all part of the business cycle. Investors should adjust their investment choices during these times.
One popular method is to buy Blue-chip stocks. Blue-Chip stocks are large companies that have been around for decades and are likely to stick around, despite potential market movements.
Their share prices might be down during these times, but these companies have sound financials and strong cash flows. These companies also tend to be more predictable and provide dividend income.
Another good option is to invest in companies that produce consumer staples. Food, drugs, tobacco, drinks, and household necessities are all products that people need as a bare minimum. Since these products are considered basic needs, people are less likely to significantly reduce their demand for them.
Key Takeaways: The Stock Market’s Affect on the Economy
The stock market is not the economy. However, stock market performance does have an impact on economic growth. Strong economic performance with fundamental drivers like robust consumer activity, low-interest rates, and positive GDP will encourage investing and affect share prices. Understanding how these two impact each other will help create an effective approach to investing and personal finances.