Does the stock market accurately reflect the economy?
- Investopedia defines a stock as 'a security that represents the ownership of a fraction of a corporation. This entitles the owner of the stock to a proportion of the corporation's assets and profits equal to how much stock they own. Units of stock are called 'shares.''
- The largest stock exchange in the world by market capitalization is the New York Stock Exchange (NYSE), with about 1.6 billion shares traded daily.
- The Dutch East India Company created the first modern stock trading system in Amsterdam to raise capital. '...the company decided to sell stock and pay dividends of the shares to investors,' leading to the creation of the Amsterdam stock exchange in 1611.
- The stock market lost fourteen billion dollars in one day on October 29th, 1929, otherwise known as Black Tuesday, leading to the US economy shrinking 'by more than 36% from 1929 to 1933, as measured by Gross Domestic Product (GDP). Many US banks failed, leading to a loss of savings for their customers, while the unemployment rate surged to over 25% as workers lost their jobs.'
The stock market is one of the leading indicators of the economy, and although it can fluctuate day-to-day or in response to a particular anomaly, in the long-term, it is an accurate snapshot of what's financially going on across the nation. President of World Money Watch Kimberly Amadeo agrees, saying, 'The stock market is an excellent economic indicator for the US economy. It reflects how well all listed companies are doing.' And financial analyst Bruce Allen reinforces the importance of the many meaningful statistics that the stock market indexes provide: 'stock and stock futures markets; bond and mortgage interest rates, and the yield curve; foreign exchange rates; and commodity prices, especially gold, grains, oil, and metals.'
Many factors that drive the stock market also drive the economy. The confidence of investors leads to the buying of stocks, and the confidence of consumers brings about spending—linking the two together. Consequently, a lack of confidence slows both spending and investing.
Further, the health of the economy can easily be seen in the market when businesses grow. Growth becomes profit, resulting in higher prices of traded stock for those companies on the market, and reflecting the special connection that the economy and the market share.
It's important to note that the market's mirroring of the economy is not seen at a glance but rather via macro measurements—estimates are about six months into the future. Therefore, any usable information must be measured in long-term increments, as the market can fluctuate in the short term.
The stock market does not reflect the economy because it only accounts for 50% of the GDP (i.e., the investment part). The stock market also does not capture the value of consumer spending on goods and services. In fact, small businesses generate two out of every three new jobs and are estimated to account for nearly half of total economic output. Moreover, the government can impact the economy by injecting cash in the form of stimulus payments to boost consumer spending.
Further, the stock market can rise due to factors that don't necessarily correlate to overall economic health. Companies often use excess corporate cash to buy back their own stock to buoy the market price, regardless of their financial health. The current stock market valuation is over-weighted by technology giants—a handful of which account for over one-fifth of the S&P 500 index value.
The stock market also does not always behave rationally; it can overreact to unexpected news. Recently, two companies announced CEO changes (i.e., Amazon and Qualys), and their stock prices were battered despite reporting highly favorable quarterly earnings announcements. In Qualys' case, the stock fell from 130 to 103 in two days, a decline of over 20%.
The stock market can give a false impression of the true health of the economy. While investors bid up the shares of tech stocks like Apple and Alphabet, many millions of Americans remain sidelined after being laid off during the COVID-19 outbreak, resulting in an avalanche of business closures (including over 110,000 restaurants) and payroll cutbacks.