How does the stock market relate to the economy?

The stock market and the economy are often discussed simultaneously, giving the impression that they might be the same thing. So just to be clear: The stock market is not the economy. Although the stock market and the economy do mostly move in the same general direction over the long run, they are two different things entirely.

The stock market is where investors connect to buy and sell investments—most commonly, stocks, which are shares of ownership in public companies. People will often refer to one of the major stock market indexes, like the Dow Jones Industrial Average or the S&P 500 when they talk about the stock market. That’s because it’s hard to track every single stock and these indexes are considered to be representative of the entire market.

The economy is the relationship between production and consumption activities that determine how resources are allocated. The production of goods and services is used to fulfill the needs of the people who are consuming them. Very simply put, this is our economic system.

The stock market can be an indicator when it comes to how the economy is performing, but it is just one indicator. Put simply, the stock market and the economy are not one and the same.

A closer look at the stock market

In the early 1600s, countries like Britain and Holland needed a way to make their bank accounts larger to progress as industrialized countries. The powers that be looked for companies that were doing well and made them a deal to trade them some money in exchange for a small part of their profits. To say that it went well is an understatement.

We’ve come a long way since the 1600s. In the United States, there are two stock exchanges that you’re probably familiar with. The New York Stock Exchange dates back to 1792 and is the largest marketplace to buy and sell stocks and bonds in the world. The NASDAQ is a totally digital stock exchange where you can trade a lot of big tech companies, like Apple and Facebook (in addition to some non-tech companies, as well).

Since its inception here in the U.S., the stock market has historically returned profits to its investors. Stock market returns do vary greatly from year-to-year and rarely fall into the average range, but with that being said, over the last 100 years, the stock market’s average annual return is about 10%, before inflation is taken into account.

A closer look at the economy

Everything the U.S. economy produces is measured by gross domestic product, or GDP. When the GDP’s growth rate turns negative, the economy enters a recession. When that recession lasts for several quarters it can be deemed an official depression, which happens by a secret committee.

GDP is one of the most common indicators used to track the health of the economy. It represents the total dollar value of all goods and services produced over a specific time period, often referred to as the size of the economy.

For stock prices to grow faster than the GDP, either price has to grow faster than earnings or earnings have to grow faster than GDP.

The indicators of a strong economy are strong employment numbers, higher wages, increased retail sales, steady inflation, rising interest rates, more home sales, and an uptick in the manufacturing of consumer goods. Of those, the most important is consumer spending.

A growing economy can lead to a strong, or bull, stock market. When companies are doing well, a drop in unemployment will coincide with a rise in corporate profits and consumer spending will increase. People are working, earning money, spending more, and saving more. On the other hand, a more passive, or bear, market indicates a slowing economy with investor fear and pessimism.

How the stock market impacts the economy and vice versa

So, in spite of often being conflated with the economy, the stock market is an entirely different animal. The stock market is driven by the emotions of investors while the economy is the created wealth and resources in terms of the production and consumption of goods and services. They often do impact each other, but they are not the same.

The stock market impacts the economy because it influences consumer confidence, which in turn influences the overall economy. The relationship also works the other way, in that economic conditions often impact stock markets.

Understanding how they work together

The stock market works the economy in several ways, beyond acting as a symbiotic indicator. Stock purchases allow an individual investor to own part of a company. Thanks to the invention of stock markets, it’s not just the large private equity investors and institutions that can profit from the free-market economy. Investing in the stock market can also help investors beat inflation over time. Remember that over time the market has historically returned about 10 percent to its investors—that’s way more than parking it in a savings account. Though that is a good idea as well for emergencies and short-term goals. (And, of course, past performance does not necessarily guarantee future results.)

Another way that the economy and the stock market work together is through strengthening new business. Growth-oriented companies require capital to fund momentum and the stock market is an important source. For this to happen, owners sell part of the company and “go public” with an initial public offering (IPO) of the shares. An IPO raises a lot of cash and can lead to general excitement around companies that are poised for growth in this way. Perhaps more importantly, it indicates they’re profitable enough already to even afford the IPO process, which can cost millions.

When companies go public and enter the market, people get excited and buy shares, which funds growth on their end, and bolsters confidence on ours.

Investing in a volatile market or down economy

Investing during a down market or recession may mean making different investment choices. There are a few options that are popular with investors in these conditions. Blue-chip stocks are one. Blue-chip stocks are the big names that you know that are not likely to go anywhere soon. These stocks all have a few things in common: strong cash flows and sound financials. They’re stocks that you can own and sleep well at night regardless of the market’s ups and downs. Be aware that blue-chips generally sacrifice some growth potential in exchange for greater predictability and dividend income, but that’s what many people look for in a down market.

You can find several blue-chip holdings in Public’s Cash Cows Theme. McDonald’s, Wells Fargo, and the iShares US Financial Services ETF are all examples of blue-chip holdings.

Consumer staples could be another strong option. Examples of consumer staples include food, drugs, drinks, tobacco, and basic household products. These are things that people are unlikely to reduce their demand for when times are tough because people see them as basic needs. Companies that fit this category are woven throughout just about every Public theme, from Click It, Ship It to Health and Wellness.

The bottom line

While the stock market and the economy, often conflated, are very different things, they do impact each other. Understanding both, and how they reflect each others’ ups and downs, is key in setting a holistic approach to investing and finance. Dollar-cost averaging is a helpful tool to stay accountable no matter how the market is performing and smooths out highs and lows over time.

The above content is provided is paid for by Public and is for general informational purposes only. It is not intended to constitute investment advice or any other kind of professional advice and should not be relied upon as such. Before taking action based on any such information, we encourage you to consult with the appropriate professionals. We do not endorse any third parties referenced within the article. Market and economic views are subject to change without notice and may be untimely when presented here. Do not infer or assume that any securities, sectors or markets described in this article were or will be profitable. Past performance is no guarantee of future results. There is a possibility of loss. Historical or hypothetical performance results are presented for illustrative purposes only.