The Stock Market and the Economy: Why is one up and the other down?

After increasing steadily since April, the Dow erased it's 2020 losses by end of August.  However, the economy as a whole continues to struggle.  Over the last few months I've been stating that the Markets have been "untethered" to the economy.      What I meant by that is that the Markets have been improving considerably while the health of the economy is still weak.   Why is that?   Traditionally we tend to view the Markets as a measure of the strength of the economy.  It's important to note however that 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 etc. While some aspects may be related on some level, they are not all equal, nor does one impact the other equally.

The various ways we can define financial well-being speaks to why so many people think of the stock market and the economy’s health as a gauge for each other. However, the stock market does not define economic health as a whole.  As we’ve seen with the COVID-19 pandemic, 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, I 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.”  More specifically, one way we can understand economic activity is through real GDP (gross domestic product), which measures the value of goods and services.   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 might hire more employees to keep up with increasing demand. With more individuals employed and earning income, more people have money to spend on goods and services- increasing overall consumption. Sometimes, however, GDP can grow but not quick enough to create more jobs for those who are unemployed.

What Is the Stock Market? 

The stock market can be defined simply as “a stock exchange."   It is the buying and selling of ownership shares in a corporation.  The stock market consists of the buyers and sellers (with some buyers and sellers holding more “stock” than others) involved in this activity but does not consist of nor involves every business, worker and family. 

Some of the main indexes used 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).

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 regards 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.  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.  Why is there such a disconnect?

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 composed of larger publicly traded corporations that are  different than the vast majority of small businesses, workers and cities in the U.S.   These larger companies have different profits, greater access to capital,  bond markets and global trade. 

Reason #2

The stock market’s performance as a whole only represents a portion of the U.S. employed households.  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 owned a portion through mutual funds, trusts or various pension accounts. Therefore, the stock market may not display an equal distribution between those who are benefiting from Market performance and the economy as a whole.

Reason #3

It’s long been understood that at times, investors may be driven by emotional or reaction decision-making. As a result, their behavior may not be mimicking the economy’s current state nor affairs happening in real-time.   There have been large numbers of people who started investing for the first time during this pandemic.  Low interest rates have driven people to invest more in the stock market as they look for more return for their cash.  The rise in the stock market is motivating them to invest even more thus, creating another "bubble" of activity.  People who are underemployed or unemployed is viewing the stock market as a way to make up for lost income - day trading has become much more attractive.  They believe they cannot lose in this environment, thus heating up the Market even more.  Emotional investing results in increased volatility as well.  Last week's sell off of technology stocks like Facebook, Apple, and Tesla was not a result of bad business news.  Rather, it was due to investors feeling that the Markets were getting overheated and sold off companies with the largest gains.  

While the stock market may reflect some changes in the economy and vice versa, the status of one does not show the entire portrait of the other. At times, they can tell entirely different stories, as is the case with COVID-19.   As we deal with the impact of the pandemic, whether or not there will be another stimulus package, global tensions with China, or changes to Federal and Monetary policy, investors can continue to experience a roller coaster ride and further untethering of the Markets and Economy as a whole.