The economy and the stock market have a long-standing relationship. At first, it may appear that stock prices just move up and down at random. But if you snoop a bit below the surface, you might come to understand that the economy actually does have a significant influence over the direction of the stock market.
But what does the economy mean for the stock market, exactly?
This guide breaks it down. We’ll take a look at what links economic activity and stock market performance, review some important economic indicators that can push stock prices in one direction or the other, and explain how you can use this information to become a more savvy investor.
When you’re finished, you’ll have a better grasp of how the health of the economy influences stock market movements.
The Economy and the Stock Market: The Basics
At heart, the stock market is a measure of the value of public companies. Investors purchase shares in the belief that these companies will make a profit. Yet these profits are tied to the general economy.
People and businesses tend to spend more money when the economy is booming. Businesses make more money, and the result is higher profits and, therefore, higher stock prices.
Conversely, when the economy is in a downturn, such as when consumer spending is lower, credit is tighter and business is slowing, such things can cut into corporate profits and pull stock prices lower.
Now, think of the economy dancing with the stock market. The stock market follows, and the economy leads.
Investor Sentiment Gets Boost from Growth in Economy
The stock market loves a bit of optimism. During economic expansion and when unemployment is low, there is a rise in confidence, Lubrano noted. This tends to lead to increased spending, heightened demand for goods and services and, ultimately, strong corporate profits.
Investors, buoyed by the positive sentiment, buy stocks, which drive prices higher. Conversely, in times of economic downturn, fear can rule the market and lead to large sell-offs.
Some Historical Examples of Economic Effects on the Stock Market
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In the Great Recession of 2008, a collapsing housing market, tightened credit, and loss of confidence in the economy led to a worldwide crash of stock markets.
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The COVID-19 pandemic in 2020 had a swift economic slowdown with a steep fall in mid-March. Yet swift action by the government through unique stimulus measures has seen the market recover quickly on the anticipation of an economic recovery in the future.
Why the Relationship Has Imperfections
The economy and the stock market are intertwined, of course, and the stock market can be a “leading indicator.” It captures investors’ expectations of how the economy will be doing in the future, not just how it’s doing today.
That’s why stock prices can rise even as the economy is sagging: They are looking past a weak present to an eventual recovery.
4 Basic Economics Explained That Influence The Stock Market
1. Interest Rates
Interest rates, which are controlled by central banks like the Federal Reserve in the United States, are among the most immediate ways that the level of the economy affects the stock market.
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When interest rates are low, borrowing is less expensive for companies and consumers, and spending and investment tend to rise. This frequently leads to an elevated stock price.
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But higher interest rates can also work in the other direction. Rising rates can make borrowing more expensive, possibly slowing economic growth and hurting corporate earnings. But it could also spur investors to scale back on stocks in favor of fixed-income investments, such as bonds.
Pro Tip: Keep an eye out for any changes to interest rates coming out of the Federal Reserve. If those rates are expected to go up, it will likely impact other sectors (tech, we’re looking at you) who might be more sensitive to short-term changes.
2. Inflation
Inflation, or the pace at which the prices of goods and services rise, can be good or bad for the stock market.
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It is widely considered healthy and normal for moderate inflation to accompany economic growth.
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But high inflation eats away at consumers’ purchasing power and forces businesses to pay more, pressing down on profits.
(And as we know from the 1970s, extreme inflation can spook investors and lead to wild fluctuations in stock prices.)
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Deflation (or falling prices) is no better, as it tends to indicate weak demand, which in turn exerts further downward pressure on stocks.
3. Employment Levels
Nothing like unemployment rates to keep an eye on.
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High levels of employment are a sign of a strong economy as well as consumer spending that can help lift corporate profits and stock prices.
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Conversely, increasing unemployment can also dampen spending, slow economic growth, and potentially depress the stock market.
Example: Jan 4, 2019 – Traders are on the lookout for any major economic figure, such as the US Non-Farm Payroll, as this can be a key indicator of whether an economy is weakening or strengthening.
4. Corporate Earnings Reports
Better corporate earnings are driven by good economic conditions.
- Investors pay attention to quarterly earnings to measure a company’s financial health and growth prospects.
- A good earnings season can help to power a market rally, while bad earnings can choke off stocks in the blink of an eye.
Key industries to watch:
- Tech and Retail – sensitive to consumer demand.
- Financials – interest-rate-and-credit-sensitive.
- Energy – tied to global financial conditions.
Consumer Confidence
The Consumer Confidence Index gauges whether people are feeling good or bad about their financial health.
- Plenty of confidence usually fuels spending and investing, good for the market.
- When confidence is low, investors may decide to hoard their cash, which can be a brake on market momentum.
Investor Perspective: Navigating the Economic Fallout
Diversify Your Portfolio
Never stake everything on one horse (or: Don’t put your eggs in one basket).
- Reduce risk: Diversify with a mix of stocks, bonds, and alternative assets.
- Diversification may help your portfolio avoid overreacting to market extremes catalyzed by economic shifts.
Watch the Trend in Economic Indicators
- Keep an eye on key economic indicators such as GDP growth, inflation, and employment numbers.
- Use this knowledge to forecast potential challenges or opportunities in the marketplace.
Invest for the Long Term
The stock market may be volatile because of short-term economic releases.
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But, in the long run, investment timelines minimize smaller bumps like this, resulting in substantial and consistent growth.
Consider Defensive Stocks During Downturns
Source: Think Defensive Stocks in a Downturn 12-11-18 f By: L Revkin r 0657nyt SAVE this 12-11-18 Listed below
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Industries such as health care, utilities, and consumer staples typically do well even when the economy is slowing.
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These stocks, sometimes referred to as “defensive stocks,” are less sensitive to reduced consumer spending.
Consult Financial Experts
Many investors have trouble keeping up with quickly changing economic and market conditions.
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A good financial planner can also customize your investment plan according to today’s economy.
What Lies Ahead?
The correlation between the stock market and the economy is like a Rorschach test.
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By understanding how economic factors affect companies, you can make better decisions and create a durable and resilient portfolio.
Whether you’re dealing with interest rate changes, inflation fears, or consumer behavior shifts, always remember that a balanced approach is crucial to ride out the market’s ups and downs.
The relationship between the economy and the stock market may not always appear to be obvious, but if you follow the economic indicators and trends, you can put yourself in the driver’s seat when it comes to being prepared for what’s ahead.
