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The Stock Market and the Economy Are Not the Same: A Guide to Understanding the Difference

"How can the stock market be doing so well when the economic news I hear each day is so discouraging?"  Small businesses are closing, unemployment is up, your own family's financial stability may have taken a hit as the COVID-19 pandemic swept across our country.  How can these differences be reconciled?  And, more importantly, how can you make sense of the facts in order to make good financial decisions for yourself and your family?

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 are interrelated, they are not all one and the same.  The stock market does not define the country's economic health as a whole. 

As we’ve seen since the initial COVID-19 shutdown here in the US in March, 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 usually hire more employees to complete such production. With more individuals employed and gathering paychecks, more people have money to spend on goods and services - increasing overall consumption.Conversely, when demand for goods and services falls, some workers are laid off in order for companies to economize and survive.  This would be a time of falling GDP.  Therefore the GDP is a useful indicator for assessing the economy as a whole, across all sectors.

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 of buyers and sellers of shares of companies large enough to be publicly owned. It is not necessarily indicative of every business, worker and family in the country. 

Some of the main indexes we use here in the US 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).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 regard 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? Here are a few reasons.

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 corporations, many of which are quite large, and doesn't take into account  small businesses, small farms and cottage industries which make up a significant percentage of GDP.  These larger companies have different strategies, greater access to capital, bond markets and global assets than smaller businesses do. 

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 participated in the stock market through mutual funds, trusts or various pension accounts. Therefore, the stock market is unlikely to reflect the financial health of all groups who make up the economy as a whole.9

Reason #3

It’s long been understood that at times, investors may be driven by emotional  decision-making. As a result, the stock market can be affected by both fear and confidence not necessarily related to hard facts.  The behavior of investors may not mimick the economy's current state as measured in the fact-based GDP.

While the stock market may reflect some changes in the economy and vice versa, the status of one does not show the complete picture of the other. At times, they can tell entirely different stories, as has been the case during the COVID-19 shutdown. This is one of the reasons it is good to contact your fee-only financial planner before making decisions related to your own investments.  Having an advisor who is a fiduciary (works only in your best interest) and not emotional about your money, helps your interaction with the stock market over the long run to bring gain. 

  1. https://www.lexico.com/en/definition/economy
  2. https://www.imf.org/external/pubs/ft/fandd/basics/gdp.htm
  3. https://www.lexico.com/en/definition/stock_market
  4. https://www.econlib.org/library/Columns/y2010/Murphystockmarket.html
  5. https://www.investopedia.com/ask/answers/032415/what-are-most-common-market-indicators-follow-us-stock-market-and-economy.asp
  6. https://www.marketwatch.com/story/its-been-100-days-since-coronavirus-sent-the-stock-market-to-rock-bottom-heres-what-comes-next-after-its-best-rally-over-that-period-in-80-years-2020-07-01
  7. https://www.bea.gov/data/gdp/gross-domestic-product
  8. https://www.bls.gov/news.release/pdf/empsit.pdf
  9. https://www.nber.org/papers/w24085.pdf

This content is developed from sources believed to be providing accurate information, and provided by Twenty Over Ten. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. 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.