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

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

When we think of financial health, a few things might come to mind. We may think of our financial status, our investments, the Dow Jones Industrial Average performance, the stock market as a whole, the economy, the country's employment rate, and so on. While some aspects may be interrelated on some levels, not all these factors are the same, nor do they all indicate one another's overall health or status. 

The various ways we can characterize 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 during the COVID-19 Pandemic, stocks are regaining lost high, but for many individuals - and the country as a whole - we are still facing the effects of business closures, record-breaking unemployment, and across the board business disruptions. 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." More specifically, we can understand economic activity 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 increases or decreases.

Economic Health in Terms of GDP and Employment 

Naturally, employment may rise as production and consumption increase. To produce more goods, companies, and factories hire more employees to complete such production. With more individuals employed and earning paychecks, more people have money to spend on goods and services- increasing overall consumption. Sometimes, however, GDP can grow but not quickly enough to create enough jobs for those looking for work. This creates unemployment. 

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 is comprised, therefore, of the buyers and sellers (with some buyers and sellers holding more "stock" than others) and is not necessarily indicative of 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? A few reasons below.

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 companies that are different than small businesses, workers, and cities in the U.S. - with different profits, greater access to bond markets, and global positioning. 

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 was 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 even though half of all households owned a portion through mutual funds, trusts, or pension accounts. Therefore, the stock market may not display an equal distribution between those who make up 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. While the stock market may reflect some changes in the economy and vice versa, one's status does not show the entire portrait of the other. At times, they can tell entirely different stories, as is the case with COVID-19. Considering other factors such as unemployment can provide a fuller depiction of the state of the economy and its residents' financial well-being. 

As you can see, there are many reasons why the stock market's headlining activity doesn't necessarily correlate to the economic health of main street America. Understanding the difference between these to significant aspects of American life is vital as we face an uncertain recovery and continue to navigate a volatility stock market.