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"The stock market is like a small row boat on a rough sea, bouncing around as it drifts, whereas the macro economy is like
a large ocean liner, very ponderous and difficult to maneuver but without such a rough journey."
Clive Granger
A Common Misconception
Many individuals assume the terms “market” and “economy” can be used interchangeably in reference to the overall financial system - or, "all things having to do with money, investments, institutions, governments, etc." However, as will be explored, the two – market and economy – mean quite different things.
When we think of the broader financial system we may consider a country’s employment/unemployment rates, the Consumer Price Index (CPI), personal investments, the ups-and-downs of market indexes and stocks, government spending, interest rates, or any number of other statistics. Although these figures are often related, they do not always move together (nor do they necessarily help predict or understand the other.)
This article examines what we mean when we use the terms “market” and “economy,” and how the two interact with one another to provide a snapshot of the overall health of the financial system, etc. in the United States.
What is the Economy?
Broadly, the economy in any given country is made up of all activities (goods and services) related to earning (production) and spending (consumption) money within a country's borders (in contrast to GNP, Gross National Product, which includes economic activity abroad by a country's nationals.) In addition to the Gross Domestic Product (GDP), metrics for measuring the health of the economy include consumer spending, the housing market, the Consumer Price Index (CPI) and employment rates.
There are a few different ways to calculate GDP, but the general formula is:
GDP = private consumption + gross private investment + government investment and spending + (exports – imports)
Alternatively, GDP figures (by state, sector, etc.) can be tracked using the Bureau of Economic Analysis (BEA) website: https://www.bea.gov/data/gdp/gross-domestic-product
The GDP in the United States typically correlates to the health of the overall economy. It is natural to assume, then, that this is also true of the (stock) market. Before addressing that point, though, let’s unpack the meaning of “market.”
What is the Stock Market?
The total US stock market is the amalgamation of all stock exchanges in the United States – it’s an informal way of characterizing the places where stocks are bought and sold. Parts of the market have indexes – the S&P 500 (a market-capitalization-weighted index), for example – as do exchanges (the New York Stock Exchange (NYSE), for example, is made up of over 2,000 companies and is indexed as “NYA.”)
The same logic applies to the total world market - it's a combination of all possible exchanges, etc. where buying and selling takes place. Common indexes used to track the world stock market include the FTSE All-World Index and the MSCI All Country World Index (ACWI).
If the “market” represents publicly traded companies (on exchanges across the United States), then we can understand the market to be representative of buyers, sellers, and public companies (but not of individuals who do not participate in the market nor private companies.)
In short, the market is not representative of all the variables regarding participation in the economy.
The Relationship Between the Market & Economy
The total US stock market and economy, generally, trend similarly on extended timelines. However, their short-term movements often differ drastically from one another. Without delving into particular macro/microeconomic particulars, the trends and divergences can be understood in the following ways:
It's All in the Perspective
From our vantage-point (the present), economic indicators and reports typically lag behind our current reality. For example, the Consumer Price Index (CPI) measures the change in the prices of goods and services from today to that of a selected period in the past. While economic indicators typically rely on historical data, the stock market tends to be more “forward-looking” – investors purchase stocks today because they believe a company’s earnings, etc. will increase in the future.
Tilting Toward Large-Cap (Public) Companies
As noted previously, the total US stock market tends to move in tandem with large corporations (for example, the top 10 companies in the S&P 500 make up about 30% of the index’s total market capitalization1) because they have much more access to broad capital markets. However, what of small (non-public) businesses in the Unites States?
According to the US Small Business Administration2, “Small businesses are the lifeblood of the U.S. economy: they create two-thirds of net new jobs and drive U.S. innovation and competitiveness. A new report shows that they account for 44 percent of U.S. economic activity.”
Participation in the US Stock Market
Related, to the point above, another significant consideration is individual participation in the stock market(s) versus the economy. All consumers and producers in the United States participate in the economy, whereas only slightly more than 50% of individuals in the US participate in the stock market.3
Changes in Fiscal and Monetary Policy
Fiscal policy, meaning the federal government's decisions regarding taxation and government spending (as approved by the legislative branch), tends to lag monetary policy. Monetary policy, as dictated by The US Federal Reserve Board (colloquially, "The Fed"), has the ability to act quickly - see the backstopping of US markets in March/April 2020. Fiscal policy typically involves large-scale drafts, changes, and approvals (bills) before implementation. While both fiscal and monetary policy affect the economy and stock market, the speed at which policies are put into place and their corresponding impact on the market and/or economy differ.
Uncertainty Leads to Volatility
Finally, as a bit of behavioral finance, economic news and reports sway the stock market. Perhaps, more than anything, what investors dislike is uncertainty – for example, will employment numbers be better or worse than anticipated, and how will this impact the market? When the figure is released – good or bad – there’s no uncertainty. Another salient example, unrelated to economic indicators, is that of market returns during election/midterm election years. Historically, the months leading up to an election are far more volatile than the months following – regardless of the outcome. As was illustrated in the quote at the top of the article, the market tends to be more volatile and reactionary, whereas the economy (due to the number of contributing factors) is a bit more laborious in its movements.
Investing for All Market & Economic Cycles
In general, it is understood that daily market movements do not accurately explain what is happening in the economy. However, many investors believe that it does (or should.)
Learning the dynamics of the relationship between the stock market and economy may help interpret economic news and stay focused on long-term investment goals (and, potentially, improve financial decision-making.) For these reasons, it is generally recommended to diversify investments across asset classes and sectors to potentially mitigate the risks associated with the volatility of different economic and market cycles.
To conclude, there are fundamental differences between the market and economy which are more pronounced in short time periods. Over the long-run the stock market and the economy tend to have a stronger correlation. The stock market may reflect changes in the economy and vice versa, but the present standing of one does not always help explain the other. Oftentimes, the market and economy (without proper reference) can provide entirely different sets of information.
- https://www.spglobal.com/spdji/en/indices/equity/sp-500/#data
- https://advocacy.sba.gov/2019/01/30/small-businesses-generate-44-percent-of-u-s-economic-activity/
- https://www.pewresearch.org/fact-tank/2020/03/25/more-than-half-of-u-s-households-have-some-investment-in-the-stock-market/
Diversification and asset allocation are methods used to help manage investment risk; they do not guarantee a profit or protect against investment loss. The content is developed from sources believed to be providing accurate information. All investing involves risk, including the possible loss of principal, and there is no guarantee that any investment strategy referenced here will be successful. The information in this material is not intended as tax or legal advice. 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. This material was developed and produced by RP Wealth Advisors to provide information on a topic that may be of interest. 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.