Insights

The Stock Market and the Economy – How do they impact each other?

The “Stock Market” and the “Economy” are two terms often tangled together in misconception. Let us start with a definition of terms. The “Stock Market” refers to the collection of markets (such as the S&P 500, the NASDAQ, or The Dow Jones) where regular activities of buying, selling, and issuing shares of publicly-held companies take place. So when someone asks “how did the markets do today?” they are asking if the indices were up or down.  The “Economy,” on the other hand, is the wealth and resources of a country in terms of production and consumption of goods and services and the supply of money.

Although these two terms are often used interchangeably, they are not one and the same.  They do however impact each other.  For example, a strong economy can create fears that inflation is on the rise.  Fears about inflation drive worries for investors that the Federal Reserve could raise interest rates faster than indicated. The worries about the Fed fuel a long-held view that rising rates kill bull markets, partly because companies tend to have slower growth when money becomes more expensive to borrow.  All this worry and anxiety can lead to a simple conclusion: Sell.

We saw an excellent example of this fear and subsequent drop in the stock market play out in February and December of 2018. Investors began to fret about the state of the economy, specifically that things seemed too good to be true and that inflation is beginning to pick up. Economic reports told us that production was increasing, unemployment rates were falling, wages were increasing, all of which are contributing factors to a higher gross domestic product (GDP) and inflation. Investors began to fear that if the Federal Reserve raised rates to combat inflation, the bull market we’ve been enjoying for so long would be compromised. This led to the sharp sell offs we saw in February and again in December. So in February we saw a 11% sell off as well as a 20+% sell off in December. Luckily, both dips in the market were followed by swift recoveries.

The following are examples of stock market crashes and some of the contributing economic factors:

The Stock Market Crash of 1987 – Heated tensions were building in the Persian Gulf, interest rates were rising, and the market was in a five-year bull market without any meaningful corrections. The development of computerized trading allowed people to put in stop limits on positions, which contributed to a domino effect of sells taking place. While this didn’t cause any economic damage in the real economy, economic growth had already begun to slow and inflation was on the rise.  The US cut interest rates in fear the stock market crash would cause a recession, which instead caused an economic boom with rapid rates of economic growth.

The Tech Bubble of 2000 – Thanks to the technology boom at the turn of the century, we were seeing market exuberance never felt before.  Everyone wanted a piece of the technology pie and that sector began to outsize itself in the S&P 500 and shares began to become overvalued.  There was excessive speculation during a period of extreme growth with the adoption of the internet.  In response, interest rates were increased, which led to deep volatility in the market and ultimately caused the great sell-off.

The Great Recession of 2008 – This correction reflected real economic problems.  Banking and mortgage concerns started to appear and impact the financial sector. Several events concerning the debt problems bled out in the market causing the biggest one day drop since the Crash of 1929 in September 2007.  Confidence fell, which reduced corporate spending and led to a loss of jobs and decrease in consumer spending.

How do we use economic indicators to help us try to anticipate the direction of the stock market? While we certainly do not have a crystal ball, we look at a variety of measurements such as GDP, employment rates, and jobless numbers as clues to where the economy is going. The consumer price index, producer price index, and retail sales are also seen as indicators of the health of the economy, by telling us how the consumer is feeling about the economy.

Additionally, understanding the government’s use of Fiscal Policy and the Federal Reserve’s Monetary Policy is another way in which we can predict the stock market’s reaction to change. Fiscal Policy, implemented by the president and congress, is used to either pump money into a failing economy through government expenditure or take money out of the economy by raising taxes. Monetary Policy is the Federal Reserves raising or lowering interest rates for banks, which trickles down to affect what price businesses can borrow money to continue growing.

In the end, the stock market and the economy are not the same.  However, they heavily influence each other. This relationship is something we will continue to track as we monitor the investing landscape.

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