The Stock Market and the Economy Are Not the Same: A Guide to Understanding the Difference
When you think of financial health, what is it you mean? Generally, this could mean a few things, you may be thinking of your own financial status, your investments, the Dow Jones Industrial Average performance, the stock market as a whole, the economy, the country’s employment status and so on. 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. Further, their interplay could actually change over time!
The various ways we can characterize financial well-being speaks to why so many people think of the stock market and the economy’s health as a gauge for each other. However, the stock market does not define economic health. As we’ve seen with COVID-19, stocks are back on the rise, though we are still facing the effects of business closures, record-breaking unemployment rates, supply chain issues and inflation. So why is this? Below, we outline the major differences between the stock market and the economy and why one can progress while the other tells a different story.
What Is the Economy?
The economy can be defined as “the wealth and resources of a country or region, especially in terms of the production and consumption of goods and services.(1) More specifically, one way we can understand economic activity is through real GDP (gross domestic product), which measures the value of goods and services while factoring inflation into the equation. As a result, understanding the health of the economy can be thought of in terms of the growth rate of real GDP, meaning whether the production of goods and services is increasing or decreasing.(2)
Economic Health in Terms of GDP and Employment
Naturally, employment may rise as production and consumption increase. To produce more goods, companies and factories might hire more employees to complete such production. With more individuals employed and gathering paychecks, more people have money to spend on such goods - increasing overall consumption. Other times, due to increased technology and other factors, productivity of workers can increase to create additional growth. Sometimes, however, GDP can grow but not quick enough to create more jobs for those who are unemployed. (2)
What Is the Stock Market?
The stock market can be defined simply as “a stock exchange.”(3) It is the buying and selling of ownership shares in a corporation.(4) The stock market is comprised, therefore, of the buyers and sellers (with some buyers and sellers holding more “stock” than others) and is not necessarily indicative of every business, worker, and family. In fact, one could argue the day to day swings in asset prices are very large compared to the actual change in business fundamentals on a daily basis.Some of the main indexes used to understand how the market is performing are the Dow Jones Industrial Average (tracking of 30 leading companies), the S&P 500 Index (500 stocks across all industries), and the Nasdaq Composite Index (a dynamic mix of 3,000 stocks across the technology, biotechnology, and pharmaceutical sectors).(5)
The stock market and the economy can display very different pictures of “progress.” One such example is with COVID-19. In regard to the stock market, the major indexes including the S&P, the DJIA and the Nasdaq Composite index all have surged since the market downturn in March.6 The stock market has long been a leading economic indicator and moves often in advance of economic data.
Reason #1
When considering the make-up of the S&P, DJIA, and Nasdaq Composite indexes, the stock market isn’t representative of all who make up the U.S. economy. It is largely made up of companies that are different than small businesses, workers, and cities in the U.S. - with different profits, greater access to bond markets and global positioning.
Reason #2
The stock market’s performance only represents a portion of the U.S. employment market. A study conducted by the National Bureau of Economic Research showed that the wealthiest 10 percent of households in the United States were in control of 84 percent of the total value of stock shares, bonds, trusts, and business equity, and over 80 percent of non-home real estate. This was true even though half of all households owned a portion through mutual funds, trusts, or various pension accounts. Therefore, the stock market may not display an equal distribution between those who make up the economy as a whole.(9)
Reason #3
It’s long been understood that at times, investors may be driven by emotional decision-making. This is especially true over short time frames, like days and weeks. As a result, their behavior may not be mimicking the economy’s current state nor affairs happening in real-time. While the stock market may reflect some changes in the economy and vice versa, the status of one does not show the entire portrait of the other. At times, they can tell entirely different stories, as is the case with COVID-19. Considering other factors such as unemployment can provide a fuller depiction of the state of the economy and the financial well-being of its residents.
Sources:
1. https://www.lexico.com/en/definition/economy
2. https://www.imf.org/external/pubs/ft/fandd/basics/gdp.htm
3. https://www.lexico.com/en/definition/stock_market
4. https://www.econlib.org/library/Columns/y2010/Murphystockmarket.html
5. https://www.investopedia.com/ask/answers/032415/what-are-most-common-market-indicators-follow-us-stock-market-and-economy.asp
6. https://www.marketwatch.com/story/its-been-100-days-since-coronavirus-sent-the-stock-market-to-rock-bottom-heres-what-comes-next-after-its-best-rally-over-that-period-in-80-years-2020-07-01
7. https://www.bea.gov/data/gdp/gross-domestic-product
8. https://www.bls.gov/news.release/pdf/empsit.pdf
9. https://www.nber.org/papers/w24085.pdf
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