The beginning of 2022 was not easy for the stock market. As of June 30, 2022, the market experienced its worst start to six months since 1970, with the S&P 500 down nearly 21%. And yet, the economies of the US and other Western countries have been consistently strong, and the labor market has been one of the tightest on record (causing significant inflation).
So what gives? Shouldn’t the market be driven by the economy?
It turns out it’s not that easy.
According to London Business School professors Elroy Dimson, Paul Marsh and Mike Staunton, there is only a small positive correlation between GDP growth and stock returns. In fact, the professors have noticed that there is actually a negative correlation between national GDP per capita growth and stock returns.
While what happens in the economy and the market may not be 100% connected, knowing the difference between the two and their relationship to each other is helpful in understanding your own financial journey.
What is the stock market?
A stock market is a collection of company shares and other financial securities traded on exchanges or over the counter that investors can buy and sell.
While the value of these financial securities rises and falls over time, market dynamics (as defined by the S&P 500) tend to follow company earnings.
Source: RBC Asset Management
What is an economy?
The economy is production and consumption… thingswhether it be goods or services. The most common indicators characterizing the state of the economy are the level of employment, GDP (gross domestic product) and inflation.
When employment is high, GDP is growing, and inflation is low and stable, the economy is likely to be in good shape.
However, when these numbers get out of hand, we begin to see economic problems.
While GDP, employment and inflation are important economic indicators, they are retrospective or “lagging” indicators. This means that they only describe what It has happened compared to what should happen.
What happened to the shutdown?
There are several reasons why the stock market and the economy are not keeping pace.
1. Many people in the economy do not participate in the stock market
The number of Americans who own stocks is much smaller than those who participate in the real economy.
Only 58% of Americans report owning stocks, with the top 10% owning 89% of all US stocks, according to Gallup.
Because a large percentage of Americans own no stocks, and even fewer own a majority of US stocks, their individual actions do not always accurately reflect the buying behavior of the general population or the willingness of businesses to invest in new projects.
2. Listed companies represent a small fraction of US employment.
State-owned companies make up less than 1% of all US companies and one-third of US nonfarm payrolls.
Source: Tenor.com
Since much of the US job market is not driven solely by public companies, fluctuations in the stock market do not always result in massive job losses and economic downturns. While what happens in the stock market may affect the decisions of non-public companies, this is not a direct relationship.
Read more: Why You Shouldn’t Worry About the Stock Market Falling in a Recession
3. The largest companies by market capitalization disproportionately influence the stock market
Most people think of the stock market as the S&P 500, but the S&P 500 is only a collection of the top 500 US public companies by market capitalization. (“Market capitalization” refers to the total value of a company’s shares.)
If you compare this to the roughly 4,100 public companies in the US, it’s easy to see that S&P 500 companies do not make up the majority of US public companies. In fact, the S&P 500 has historically accounted for about 80% of the entire US stock market capitalization, so the companies in this group have a disproportionate amount of influence on the market as a whole.
Also, because the S&P 500 is defined and weighted by a company’s market capitalization, its member organizations may not represent the largest employers in the US. For example, as of July 10, 2022, Apple was the largest company in the S&P 500, but it is not even close to the top five US employers. This list is topped by Walmart, Amazon, Home Depot, FedEx and Target.
Since the stock market rewards companies with higher market capitalizations for generating more revenue, operating profits, and earnings per dollar of necessary spending, it’s understandable why the stocks of the largest and most powerful companies may not have the greatest impact on the economy.
The stock market looks ahead while economic data looks back.
Returning to the idea that a lot of economic data is retrospective, the stock market is a forward looking indicator.
Source: RBC Global Asset Management
This means that market participants are always anticipating what might happen in the future, in the form of profit expectations. If investors think that companies will have better prospects tomorrow than they do today, they are more likely to invest, which in turn will push the stock market up.
On the other hand, if investors think that companies will perform worse in the future than they have in the past, they are more likely to sell their shares, which, if done all at once without the counterweight of buying, will cause the market to fall.
Since there are many well-documented cases in economic history where market participants have misjudged the future prospects of companies, this is another reason why what happens in the stock market does not always reflect what happens in the economy.
Read more: 11 Myths About Investing in the Stock Market – Debunked
Bottom Line: Why These Differences Matter to You
The main reason why what happens in the market is important for the economy boils down to one thing: how people and companies feel about their finances.
When the stock market is hot, both businesses and individuals tend to feel better about their current and future economic prospects, leading to the so-called “wealth effect”. This is the idea that when a person gets richer through higher asset values, they spend more. For businesses, this could be in the form of increasing hiring, investing in growth programs, or going public. For individuals, this simply means an increase in overall spending, which in turn boosts the economy.
The wealth effect is currently being amplified by news and social media, adding fuel to the fire in both ups and downs in the markets.
Read more: Economic Bubbles: What They Are, Why They Happen, and Why You Should Care
As a result, it is important to approach what is happening in the stock market with a strong sense of perspective. Just because the stock market is down 20% doesn’t mean it’s the end of the world or you’re about to lose your job.
A more productive way to think about the relationship between the stock market and the economy is to think of it in terms of how those who make capital allocation decisions might feel about the next 12 months.
If you think about the relationship between the market and the economy in this way, you are much less likely to:
- Succumb to the wealth effect while the market is hot and overexert yourself.
- Be too pessimistic about the world and your future prospects when the market is in trouble.
Instead, you are now armed with the knowledge to embrace a healthy sense of financial conservatism that will allow you to invest for the long term like an optimist and prepare for the worst like a pessimist.
Featured Image: katjen/Shutterstock.com
