I was listening to an interview on NPR last week in which, the interviewer remarked the economy was falling apart once more, because the stock market was declining. This frustrated me some, because it is a broad oversimplification of the economy, the stock market, and how they are related. But, even common sense should help us understand that the stock market is not the principle indicator of our economy. When the stock market crashes, as it recently has, there isn’t mass layoffs or a huge disruption to our way of lives. Likewise, when the stock market soars, we don’t instantly see a strong upward pressure on our wages or a lot of new job opportunities.
Then why do people look at the stock market as an indicator of the economy? First, we need to understand what the stock market is. The stock market is a place where shares, which represent ownership in a company, are bought and sold. The stock market is arguably any and all stock/share transactions, although there are notable “exchanges” that initially created these markets, such as the New York Stock Exchange (NYSE).
An exchange is different than an index. You may hear about the Dow Jones Industrial Average (DJIA), which is a sampling of 30 companies, or the S&P 500, which is a sampling of 500 companies. There are thousands of companies, many of which are small and thinly traded, so less attention is generally given to them. The major indices (plural form of “index”) try to capture the share prices of the biggest and most important companies.
When we hear that the stock market finished up or down, they are generally referring to an index; most commonly, the DJIA or S&P 500. When these indices move, is it because of the economy? There is a timing mismatch that comes into play when answering that question. Stock prices are quoted daily, and economic output is quoted every 3 months (quarterly). In this sense, it doesn’t make much sense to tie the everyday movement of the stock market to the overall trend of the economy.
However, if companies are doing well for a sustained period of time, then it may well be because the economy is strong. And if companies are struggling with stagnant sales for several quarters, causing a decline in their stock price, then it may be because the economy as a whole is slumping. Thus, over the long run, the stock market trends and economic output show a relationship. However, the daily movement in the stock market is only one small data point in those overall trends, so it may not make sense to compare the everyday closing price of an index with the everyday condition of the economy.
Large companies now have such a large international presence, that their overall performance is growing more dependent on the global economy, and not just the US economy. While the indices generally increased with growth in the American economy, their long-term trends will continue to be more representative of the global economy. As we have seen with the latest stock market crash, the panic was due to slowdown in the Chinese economy, not the American economy.
So is it correct to think that the stock market is an indicator of the overall economy? When put properly into the context of long-term trends, there may be some accuracy in doing this; however, the stock market indices are starting to reflect the global economy more than the American economy. But, you shouldn’t try to correlate the daily stock market numbers with daily economic conditions. This just results in speculation and panic!