How much influence does the economy have on the stock market? What about the market’s influence on the economy?
First things first, we need to know that we are clear in what we’re talking about. A lot of times, especially in non-financial media, the two terms are used maybe not interchangeably, but close.
The stock market is the collection of markets and exchanges where the issuing and trading of publicly and privately held company stocks and equity happens. It is one of the most key components of our capitalist economy. It provides companies with capital in exchange for giving investors a slice of ownership.
An economy encompasses everything in the production, consumption, and trade of goods and services – from individuals to corporations to governments. No two economies are the same because they are specific to a region’s culture, laws, history, and geography. They’re ever-evolving and all-encompassing.
They may not be the same thing, but they are undoubtedly and intrinsically related to each other. The stock market is just one moving part of the economy and as such, is able to grow, change, and turn on its own. One of the main reasons that the market and the economy are able to move independently from each other is that one is micro and one is macro.
The U.S. economy is enormous and includes thousands of companies, millions of workers, and billions of dollars. The factors that go into moving it forward or holding it back are myriad. But a stock is dependent on one very specific, micro factor – supply and demand.
How does the stock market affect the economy?
The stock market contributes to the nation's economy because the U.S. financial markets are so dynamic and sophisticated and make it easier to take a company public. It also makes information on companies easy to obtain, which raises the trust of investors from around the world. As a result, the U.S. stock market attracts the most investors. It’s an attractive place for U.S. companies to go when they are ready to grow.
Price fluctuations of individual stocks are often an indicator of confidence. Rising stock prices mean investors believe earnings will improve and want to get in on that success. Falling stock prices mean investors have lost confidence in the company's ability to increase its profit margins and want to sell before things get worse. All of this buying and selling can only happen when a workforce is humming along.
How does the economy affect the stock market?
If you think about the stock market as a vote of confidence, a crash means a devastating lack of faith. Lower stock prices equal less wealth and capital for businesses, pension funds, and individual investors. Companies rely on stock sales to fund expansion and if stock prices stay down long enough, new businesses won’t grow. Companies that had invested their cash in stocks won't have enough to pay employees, or fund pension plans. Older workers will find they don't have enough money to retire.
Despite their symbiotic relationship, the stock market and the economy are not the same. The stock market is driven by the emotions of investors and is just one part of the multi-faceted, shape-shifting economy.