Why do Stocks and the Economy Diverge?

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 interrelated on some level, they are not all one and the same, nor do they all indicate the status of one another.

The various ways we can characterize financial well-being speaks to why so many people think of the stock market and the economy’s health as a 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.

What Is 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

Economic Health in Terms of GDP and Employment

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, however, GDP can grow but not quickly enough to create more jobs for those who are unemployed. ²

What Is 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 the buyers and sellers (with some buyers and sellers holding more “stock” than others) 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), though it is important to remember that these indexes are an incomplete picture of the overall global stock market.⁵

The Stock Market vs. The Economy in the Context of COVID-19

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, 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 reasons below.

Reason #1

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’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 some portion of the stock market 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

Markets are forward-looking, meaning they tend to react well in advance of observed impacts on companies. For example, if the stock market expects the pandemic to continue to strain company cash flows, we may see those expectations reflected in stock prices long before the actual impact to companies. The longer-term direction of the market then depends on how the economic outcomes compare to those expectations. If things aren't as bad as expected, negative news on the economy can be met with a positive stock market return. As a result, stock market returns may not mimic the economy’s current state nor affairs happening in real-time.

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 is the case with COVID-19. Considering other factors such as unemployment can provide a fuller depiction of the state of the economy and the financial well-being of its residents.

This content is developed from sources believed to be providing accurate information, and provided by Twenty Over Ten. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.