The Stock Market, The Economy, And The Differences Explained

We tend to associate financial health with a few things – financial status, investments, the economy, the stock market, (un)employment rate, the Dow Jones Industrial Average performance, among others. Contrary to the popular view, these metrics or indicators are not universally linked. While some aspects may be interrelated on some level, they are not all one and the same, nor do they all indicate the status of one another. 

It is understandable why people sometimes consider the health of the economy and the stock market as closely linked and interdependent. After all, there is no absolute approach to explaining financial well-being. But such considerations are not true. The stock market is not an indication of how healthy the economy is. Covid-19 has shown us this, with countries struggling economically despite the rise in stocks. 

The reasons for this are interesting but not far-fetched. This post attempts to clearly distinguish the economy and the stock market, with emphasis on why they both can operate independently. So, without wasting time, let’s get to it! 

What is the Economy?

The economy of a region or country describes its wealth and resources. It is measured in terms of how much they produce and consume goods and services. One of the key indicators of economic activity is the real GDP (gross domestic product). The GDP estimates the value of services and goods and the effects of inflation. So, the growth rate of real GDP can be used in assessing how healthy the economy is. A healthy economy is characterized by increased production of goods and services. The opposite happens in an unhealthy economy. 

GDP and Employment as Indicators of Economic Health

The natural dynamics suggest an increasing rate of employment with a growing rate of production and consumption. To boost output, manufacturers might bring in more employees to keep up. This translates to more employment and, subsequently, more paychecks. More paychecks mean more money in circulation to spend on produced goods, thus increasing consumption. All that being said, we should note that increasing GDP will only result in more employment opportunities when the growth is fast enough. 

What is the Stock Market?

What happens in the stock market is the buying and selling (exchange) of ownership shares in a corporation. So, we can say the stock market is the same as “a stock exchange.” The stock market is not representative of every business, worker, and family. Instead, the only stakeholders are the buyers and sellers, with some buyers and sellers always having more “stock” in their possession than others. 

Specific indicators are used in assessing the performance of the stock market. One of these is the Nasdaq Composite Index, a dynamic combination of 3,000 stocks from various sectors like pharmaceutical, biotechnology, and technology. Others are the S&P 500 Index with 500 stocks in all industries, and the Dow Jones Industrial Average, which tracks  30 leading companies in the US. 

The Stock Market vs. The Economy – COVID-19 as a case study

It is possible to have distinctly different directions and levels of progress in the stock market and the economy, as seen during the COVID-19 pandemic. The key stock market indexes like the Nasdaq Complete Index, the DIJA, and the S&P increased rapidly since the March market downturn. Conversely, GDP, the leading economic index, dropped by 5% in the first quarter of 2020. This increased unemployment rate, with 12 million unemployed people recorded between February and June 2020. 

What could have caused these stark differences in direction? Let’s find out below. 

Reason #1

As shown in the major indexes – the Nasdaq Composite Index, the DIJA, and the S&P, the stock market does not represent all US economy stakeholders. The companies that make up the stock market enjoy easy access to bond markets and  global positioning  Small businesses, workers, and cities  are not necessarily represented in the major indexes. 

Reason #2

The stock market and its performance PARTLY represent the US employment market.  The National Bureau of Economic Research conducted a recent study, which revealed that the wealthiest 10% of households in the United States control up to 84% of the total value of business equity, trusts, bonds, and stock shares. Furthermore, the same 10% control over 80% of the non-home real estate. This was the case, even with 50% of all households owning parts through trusts, mutual funds, or different pension accounts. So, it is clear that the stock market may show different distributions among the economy’s stakeholders.¹ 

Reason #3

Past events have shown that investors are sometimes driven by emotions when making crucial decisions. This means that their behaviors and the resulting decisions are not accurate representations of the economy’s current state. 

Finally…

The state of the economy may induce a couple of changes in the stock market and vice versa. But we cannot accurately deduce the status of one from the position of the other. Sometimes, their positions can result in different results - COVID-19 as a case study. 

Factoring in unemployment and other indexes can offer a more inclusive portrait of the financial well-being of the residents of a country, as well as the health of the economy of a country.