The Stock Market and the Economy: Understanding the Difference

When we think of financial health, a few things might come to mind. We may think of our own financial status, our 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 connected on some level, they are not all one and the same, nor do they all indicate the status of one another. 

Many people think the stock market and the economy is a direct gauge for each other. However, the stock market does not define economic health as a whole. As we’ve seen with COVID-19, stocks are back on the rise, but many individuals - and the country as a whole - are still facing the effects of business closures, record-breaking unemployment rates and more. 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. 

Defining 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 or not the production of goods and services is increasing or decreasing.²

One key way to measure an economy is via employment and consumption.  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. Sometimes, GDP can grow but not necessarily lead to more jobs for those who are unemployed. ²

Defining 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 buyers and sellers and is not necessarily indicative of every business, worker and family. 

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  

3 Reasons we are seeing a disconnect

The stock market and the economy can display very different pictures of “progress.” One such example is with COVID-19. In regards to the stock market in recent months, the major indexes including the S&P, the DJIA and the Nasdaq Composite index all have surged since the market downturn in March.⁶ On the other hand, GDP decreased by five percent in 2020’s first quarter, and as of June 2020, the number of unemployed individuals rose to 12 million since February. ^7,8 Why is there such a disconnect? A few potential explanations:  

Reason #1:  The Stock Market exchanges track the largest companies, and not small businesses.

When considering the make-up of the S&P, the DJIA and the Nasdaq Composite index, 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 is not a direct gauge of the average U.S. household. 

The stock market’s performance as a whole 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 despite the fact that 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:  The Stock Market is typically priced on the future earnings of the underlying companies. 

Since stocks are considered a financial asset, it competes with other assets available or investments available for purchase.  The valuation of stocks are based on a number of factors including the future earnings of the underlying companies.  While profits may be fluctuate in the near term, the long term outlook of earnings typically drives the valuation. 

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 we have observed recently.  As investors, it is very important to understand the differences between the economy and the market, as well as how they may influence each other.