The Link between Stock Markets and the Economy - Essay Example

The Link between Stock Markets and the Economy Executive Summary Between 1973 and 1974, there was a great fall in the value of corporate stocks (Borsworth 1975, p. 257). There was great depreciation in the values of shares which was then equated to loss of shareholders wealth. These happenings were of an unprecedented nature since the 1930s economic depression. From this historical perspective, it can then be learnt that there is a connection between the stock market and the economy of the country. The stock market has an undeniable role in business cycles and in the economy at large. Changes in the economy have an impact on the fluctuations observed in various economic tendencies. The stock market is a reflection of the investors forecast of economic trends. These forecasts are not mere guesses, they are relevant in as much as they indicate the trends in the business cycles (Borsworth 1975, p. 258). Table of Contents Table of Contents 3 Introduction 4 Stock Markets as Indicators of Economic Trends 4 The Economic Theory 6 The Stock Market as Only One of the Many Economic Indicators 7 Conclusion 9 List of References 11 Introduction This paper is an analysis of the link between Stock Markets and the Economy, stressing current and potential future issues. The historical aspect of the topic as discusses above gives a foundation on which this debate is premised. The paper looks into arguments supporting the notion on the economys relationship with the stock market. The paper also looks into contemporary arguments departing from the traditional belief stated above. Various sources andliterature will be analysed with the aim of getting a clear picture about the topic. Stock Markets as Indicators of Economic Trends The stock markets may be good indicators of the economic trends in a country. This is particularly so in countries where individuals own shares in person as compared to countries where shares are owned by institutional investors (PWC February 2013, p. 3). The stock market trends in some economies may be reliable indicators of various aspects of the economy. The US GDP, for instance is analysed looking at the relative strength observed on the stock markets. This can be illustrated using the table below: Summary of the Relationship Between the Stock Market and Economic aspects such as GDP and Employment. UK GDP UK Unemployment US GDP US Unemployment Strength of stock market price effect Moderate/Weak Weak Strong Strong How long does it take stock market price changes to have significant impact? 3 quarters 1 year 1 quarter 1 quarter Momentum effects Low Low High High Importance of trend High Low High Low/Moderate Source: PWC Analysis (PWC February 2013, p. 4). Over the years, stock markets have been viewed as mirrors of the economic wellbeing aspects such as employment in various countries (PWC February 2013, p. 3). Declines in the price of stock on the market may indicate the possibility of an economic recession. On the other hand, increase in stock prices and a vibrant stock market may be indicators of a promising economic future. Current stock prices may indicate the future of corporate financial performance. This performance has an inclination on the countrys gross domestic product. There are various ways in which the stock market links up with the economy. One of these links is the money generating effect the stock market may have on various traders. On the other hand, the performance of various corporate entities on the stock market affects the confidence that investors have in the economy of the country (PWC February 2013, p. 3). Therefore, the stock market is very relevant on the economic well-being of the country. Share prices may be used as reliable indicators of the economic performance of the country. However, in as much a stock market trends are relevant in the economy, it is imperative to note that there is a complicated interrelation. Factors such as time among others are also relevant in determination of various economic indicators. There has been a consensus among various economic and stock market pundits who have noted that the performance of the stock market has some direct influence on the economy. Increasingly over the years, factors such as confidence form a viable factor that links up the stock market and the economy. Slumps in stock market performance are always construed as effects of economic slowdown. They lower the confidence of consumers as well as the business outlook (BNY Mellon Asset Management July 2012, p. 2). The lowered confidence translates into lower purchases by the consumers. In addition, expenditure on investment is lowered; these results have a debilitating effect on the economy. There are companies that rely on the stock market for capital; when they cannot get enough investor spending, they become less productive. This has an effect on the economydue to the eventuality that the corporate sector is slowed down. The effect is felt more in countries where private investors are more as compared to institutional investors. The falling of stock prices leaves the impression that the investors are losing their wealth. This leads to lower consumption of various commodities. This trend has been noted in the U.S. and Germany. In Germany, it was noted that when stocks declined by about 100 Euros, the consumption of commodities also declined by 1 or 2 Euros. This trend is more pronounced in the US due to the fact that allocation of assets to investors is guided by the values of stocks. Also, the income classes in the US own more stocks; they participate more often on the stock exchange. The relationship between the stock markets and the economy is more pronounced in some countries as compared to others. The Economic Theory This theory intimates that there is a link between the stock market and the economy (Duca Autumn 2007, p. 3).The present value of the firms pay-out at its discounted level can be expressed in the form of the stock price. Being an expression of the real activity of the company involved, and then the stock value of each companys shares must be the link between the economy and the stock market. The theory suggests that there must a relationship between the stock market and the economic output of the nation at large. As indicated by Tobin in his theory known as Tobins Q, the value of a firm is high when its shares price is high (Duca Autumn 2007, p. 3). There is a correlation between the economic performance of the entire nation and the financial performance of the companies trading at the stock markets of the nation. Modigliani, on the other hand was of the opinion that stock prices are indicators of the wealth owned by the stock holders (Duca Autumn 2007, p. 4). This is rationalized by the fact that consumers control their consumption so as to stabilize their income or wealth. When they have increased incomes, they may buy more stocks at the stock market. This is the correlation between the stock market and the economy as per Modigliani. The financial accelerator perspective is another argument as to the correlation between the stock market and the economy. The argument is that companies raise capital on the stock market basing their capital borrowing on the amount of assets that they have. Their wealth is thus portrayed by the amount of stocks that they trade on the market. The three arguments form some of the rationales as to the relationship between the economy and the stock market. The Stock Market as Only One of the Many Economic Indicators Mark Gertler was of the opinion that the stock market is not the most accurate depiction of the economic situation in the country (Gertler 1988, p. 560). Gertler based his opinion on various theories that outlined the irrelevance of the financial structure in this discourse. In the growth and variation of growth, Gertler opines that the stock market does not deserve all the attention. In the age of the Great Depression, it was believed that the trends observed on the stock market were the main reason behind the depression. Scholars such as Keynes and Fisher could not see any other explanation as viable as stating that the stock market and the economy were intertwined (Gertler 1988, p. 561). The financial system may not be directly related with the whole economy. This is because the economy has many aspects to it. Business cycles, fiscal policies, monetary policies as well as employment level are all part of the economy. The stock market may be relevant in the economic fabric of the country, however it is not all that. There are many other factors that come to play in the discussion about the various constructs that run the economy. Gertler talks about macro-economics as a difficult subject that tries to analyse the interests of those who save as compared to those of the people who invest. Saving and investing are two complicated subjects which are in constant disconnect with each other. They are two activities engaged in by very different people. Bringing the interests of those who save and those who invest may be a complicated affair which cannot be relied upon to generate indicators of the progress of the economy at large. In recent times, there has been a global financial crisis which was caused by the bursting of the credit and housing bubble in the U.S. The economic downturns that followed hit various aspects of the global economies including the stock markets (Senbet and Gande 2009, p. 5). This in itself was an indicator as to the nature of the stock market. The market forms a part of the economy which has may other sections. The stock market in itself is not the most pronounced part of the economy. The financial and real sectors are examples of other parts of the economy. They are so pronounced that ripples in these sectors may cause widely felt consequences as was the case during the 2008/2009 global financial crisis. The use of the stock market as an indicator of economic factors may be applicable in some countries and not in others. It has been noted that in the UK, for instance, there are more institutionalized investors in the stock market as compared to the U.S. The behaviour of individual investors is quite different from that of institutionalized investors. The U.S. stock market may be more predictable than the UK stock market (PWC February 2013, p. 3). Individual investors are known to behave in certain ways as compared to institutionalized investors. The U.S. economy may be easily analysed using stock market trends as compared to the UK economy. The U.S. stock exchange is affected more by economic trends because the investors are the very consumers of the various goods being sold in the markets. Their reactions are more inclined to the on-going economic tendencies. It may be noted that the media plays a great role in fanning the perception that the stock market is the economy. The stock market may be an indicator of economic wellbeing or the lack of it, however, this notion should not be overstretched. The stock market may at times respond to economic trends in a quite irregular manner. Further it may be noted that the stock market involves trading in only a section of the economy, the listed companies only. There is more economic activity away from the stock market than there is in the market. Some people view the stock market as a market for the elite clubs. It may also be noted that trading on the stock market is highly speculative. Therefore, trends on the stock market are only speculations on the path that the economy may take. Economic analysis seeks to look back at various aspects of the market. This after-the-fact analysis explains various trends observed in the economy. The stock markets are more of before-the-fact oriented. Activity on the stock market may be deceptive on the true state of the economy. Traders may be highly active on the stock market during a period of economic downturn. This may be in anticipation of better times ahead. Therefore, it can be noted that the use of stock market trends may be a defective way of making economic analysis. The corporate world is known for its machinations. It rides on economic downturns for the benefit of the stock market traders, who are perceived as elite. Conclusion In future, it is expected that the interaction between the stock market and the economy will remain more or less the same. The stock market continues being a sector riddled in a lot of speculation. Bear and bull markets might remain unchanged in as much as stock prices are as a result of investor confidence in the market (Kelly 2010, par. 4). Again, it depends on the nature of the stock market involved. The U.S. and UK stock markets, for instance, have quite different characteristics (PWC February 2013, p. 3). Increase in liquidity boosts the stock market and thegross domestic product concurrently. Some of these trends may not change in the foreseeable future. When prices of commodities fall, the level of gross domestic product is deemed to be on the increase. Higher liquidity enhances company profits, earnings per share may also increase and the buying of stock may increase as well (Kelly 2010, par. 14).The affordability of various commodities in the market goes hand in hand with the affordability of stock. This may mean that the stock market follows trends in the real market; the market for various goods or commodities and services. There is a paradigm shift in the way that the stock market is related with the economy. In the past, economic crises were attributed to factors emanating from the stock market. Various developments have led to the determination of the fact that the economy may experience changes brought about by factors other than stock market trends. For instance, the 2008/2009 economic crisis emanated from housing and credit issues in the U.S. economy. The stock market was not involved in the first instance. List of References BNY Mellon Asset Management, 2012, "Stock Markets vs. GDP Growth: A Complicated Mixture." Viewpoint, 1-8. Borsworth, B 1975, "The Stock Market and the Economy." Brookings Papers on Economic Activity, 2, 257-300. Duca, G 2007, "The Relationship between the Stock Market and the Economy: Experience from International Financial Markets", Bank of Valleta Review, no. 36, 1-12. Gertler, M 1988, "Financial Structure and Aggregate Economic Activity: an Overview", Journal of Money, Credit and Banking, 559-598. Kelly, K 2010, How the Stock Market and Economy Really Work, viewed 27 March 2014, . PWC 2013, "Are Stock Markets Reliable Indicators of the Real Economy of the US and the UK?" www.pwc.co.uk/economics, 1-9. Senbet, LW & Amar, G 2009, "Financial Crisis and Stock Markets: Issues, Impact, and Policies." “Financial Crisis, Its Causes, Implications, and Policy Responses”, Dubai, 1-33. Read More