The Stock Market vs The Economy

What is a Stock Market? What is the Economy?

A stock represents a fractional ownership interest in a company. It entitles the stock owner to a fractional share in the earnings of that business. Earnings may be paid out as a dividend or reinvested into the business to further grow the company's net worth. Thus, the stock market is the exchange of various ownership interests in many businesses, traded in an open market. By contrast, the economy is the production and consumption of goods and services. That means it encompasses much more than the earnings of publicly traded corporations. It includes government spending, investment from privately held businesses and consumer spending.

There are many reasons that the prices of stocks can fluctuate. One key driver is the prospects of future earnings. Therefore, the economy in which a company operates can have an important impact on those future earnings prospects. That does not mean, however, that economic performance is the only factor that matters when looking at stock market performance. Here are a few important factors to consider when thinking of the stock market as compared to the economy.

Economic and Stock Market Predictions

First, economic measurements are backward looking, while stock prices are forward looking. This is a key distinction between the two. Economists can make predictions about the economy and where we are in the economic cycle, but nobody is certain until measures are released.  We cannot say for certain whether we have entered a recession or exited one until after it has happened.  In contrast, the stock market takes collected information to assess future values based on current knowledge. This can look like the stock market anticipates future performance before it happens. For example, stocks can rally during an economic recession due to market anticipation of an emergence, before it has been officially confirmed. The stock market and the economy do not necessarily move together.

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The Economy's Impact on the Stock Market

Second, other factors can drive the stock market. Sometimes, investors avoid stocks because they are concerned about the performance of the economy in which those stocks trade. This is understandable, but there are times when investors make their investment decisions based on relative comparisons. For example, consider Stock Market A, based in Country A, which appears to be growing at an average rate. In comparison, Stock Market B is based in Country B, which is showing signs of below-average growth. Now, add to the example that values in Stock market A appear very expensive (high price to earnings ratios), whereas the values for Stock Market B are historically cheap. 

In this scenario, there's no surprise in seeing investors rotate away from Stocks Market A, taking gains on investments that have performed relatively well, to invest in Stock Market B, where prices are relatively cheap. The decision is relative, not necessarily based on the strength of the economy.

Why a Good Economy Doesn't Mean a Good Stock Market

Third and finally, sometimes what is “good news” for the economy can be “bad news” for the stock market. Generally, this has to do with interest rate expectations. Broadly speaking, higher interest rates depress stock values. And, when an economy exhibits very strong performance, that can lead to higher interest rates. If further economic data comes out shows signs of continued or even greater economic strength, interest rates may raise even higher. It could also mean that interest rates are likely to remain elevated for some time. Either of which could be a negative for stock values. Conversely, the specter of a softer economy can signal lower interest rates, which could spark a rally in the stock market.

In summary, individual economic data points and the state of the economy as a whole are both important to the stock market, because the stock market depends on companies within the economy to generate earnings. However, that does not mean that the stock market and the economy always move in lock step.

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