How the Stock Market Affects the US Economy and Vice Versa
How It Affects You, Even If You Don't Invest
The stock market is an excellent economic indicator for the U.S. economy. It reflects how well all listed companies are doing. If investors are confident, they will buy stocks, stock mutual funds, or stock options. Some experts believe markets predict what the savviest investors think the economy will be doing in about six months.
How the Stock Market Affects the Economy
The stock market contributes to the nation's economy. That's because the U.S. financial markets are very sophisticated. They make it easier to take a company public than in other countries. It also makes information on companies easy to obtain. That 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.
Stocks affect the economy in three critical ways. First, they allow individual investors to own part of a successful company. Without stocks, only sizeable private equity investors could profit from America's free market economy.
Investing in the stock market is the best way to beat inflation over time. Stock prices increase 10 percent a year on average. That's enough to compensate most investors for the additional risk.
Second, stocks provide the capital for companies to grow large enough to gain competitive advantage through economies of scale. Owners use personal credit cards, bank loans and eventually even float their own bonds. But that only takes a company so far.
To sell stocks, they take the company public through an initial public offering. An IPOs raises a lot of cash. It also signals that the firm is successful enough to afford the IPO process. The only drawback is that the founders no longer own the company. The stockholders do. But they can retain a controlling interest in the company if they own at least 51 percent of the shares.
Third, stocks assess how valuable investors think the company is. When stock prices rise, it means investors believe earnings will improve. Falling stock prices mean investors have lost confidence in the company's ability to increase its profit margins.
How the Economy Affects the Stock Market
Stock prices usually rise in the expansion phase of the business cycle. The three main indices are the Dow Jones Averages, the S&P 500, and the NASDAQ. Here are the Dow's closing averages through the years.
Since the stock market is a vote of confidence, a crash can devastate economic growth. Lower stock prices mean less wealth for businesses, pension funds, and individual investors. Companies can't get as much funding for expansion. When retirement fund values fall, it reduces consumer spending. For more, see What Are the Components of GDP?
If stock prices stay depressed long enough, new businesses can't get funds to 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.
A stock market crash indicates a sudden and severe loss of confidence. An economic crisis typically causes it. For example, the Dow lost 700 points in the market crash of 2008. Investors panicked when the Senate failed to approve the bank bailout bill. The loss of confidence led to the Great Recession. In such a situation, a stock market crash can cause a recession.
The Stock Market Is Not the Economy
Despite its critical role in the economy, the stock market is not the same as the economy. The stock market is driven by the emotions of investors. They can exhibit irrational exuberance. It occurs during an asset bubble and the peak of the business cycle. They become overly optimistic even though there is no hard data to support it. The peak occurs right before a crash.
Investors confused the stock market and the economy during the Roaring Twenties. They didn't realize a recession had begun in August 1929. They kept driving stocks higher until the 1929 market crash. Many other factors caused the Great Depression. The depression ended in 1939. But the stock market didn't recover until the 1950s.