The stock market, the forex market, and the economy are inseparable entities that affect each other directly and indirectly. Most analysts gauge the health of the US economy based on how the stock market is doing at any given period of time. Some even use the stock market to predict how the economy will do in the near future.
The stock market allows people and institutions to trade in stocks. Companies use Initial Public Offerings (IPOs) to raise capital to pay creditors or expand their activities. Investors who buy the securities aim to benefit from the changes in stock prices or through direct payments and ownership rights. Since the economy largely involves the production of goods and services, there is a correlation between the market and the economy.
The Stock Market is Not the Same as the Economy
Some people mistakenly use both terms interchangeably. Although doing that is harmless, it can become harmful if it starts affecting decision making. For example, during the late Twenties, although the economy was doing badly, the stock market continued to boom until it all came crashing down not long after investors were hit with reality – the economy was doing badly. Incidentally, the markets recovered long after the economy had been nursed back to health after the war showing a clear distinction between them.
To understand their disparity with more clarity, remember that the movements in the stock market on a daily basis don’t always tell how the economy is doing. This is because shares are sometimes valued based on emotions while the economy only changes when core factors change. This unpredictability has led to some investors turning to forex trading because it is less volatile. Now let’s examine how the stock market impacts the US economy:
Companies see the stock market as a cheap source of capital. Although founders lose or dilute their control, they can use securities to leverage their expansion goals. When a company issues an IPO, more often than not it acquires a much-needed injection of money. They can use the money to expand their operations. This has two knock-on effects on the economy:
- 1. When they expand the scope of their activities, they produce more. Since economic growth is driven by the production of goods and services, the economy is bound to grow.
- 2. As produce more goods and services, they also employ more people. Low unemployment rates are an indicator of a healthy economy.
Impact on Spending
As we have seen above, when businesses turn to the stock market to finance their expansion plans, they employ more people thus lowering unemployment rates. At the same time, people’s spending power increases leading to economic growth.
Another way to look at spending patterns is to monitor the stock owners’ behaviors. Although people who own stocks are in the minority, their spending can be affected by movements in the stock prices. A downward trend in their fortunes can change their attitudes towards spending, usually negatively. When they spend less money, they can affect the economy, albeit to a lesser degree. The reverse is true if their portfolios increase in value.
In 1987, the UK aligned its monetary policy to stock market events. The market had fallen but the economy was still in a healthy position. However, fearing that there would be an economic recession occasioned by the poorly performing market, they slashed interest rates. The economy picked up on the improved interest rates and grew rapidly. The same can happen to the US economy if the policymakers ever follow this line of thinking.
Most private pension schemes invest in the markets. The profitability of their portfolios determines how much retirees will receive. If the markets plummet over a long perioforexd of time, the pension funds lose value. Consequently, the pensioners receive lower payouts and it affects their spending power – which is linked to the economy. The reverse happens if the markets grow over a long period of time.
The stock market and the US economy are correlated. It is important to remember that they are separate entities and should be treated as such. Many people do not own shares directly. However, they may be a part of the markets indirectly through pension funds. Regardless, even if you do not own shares, events in the securities market will affect you in some way as they impact the economy. The success of one can make the other doing well and vice versa.