When we think of financial health, a few things might come to mind. We may think of our own financial status, our investments, the stock market as a whole, the economy, the country’s employment status, and so on. While some aspects may be interrelated, they are not all one and the same, nor do they all indicate the status of one another.
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 one another. However, the stock market does not define economic health as a whole. As we’ve seen with COVID-19, the last big decline the economy has faced, stocks were back on the rise at the end of 2020, but many individuals – and the country as a whole – were 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
The Health of the Economy in Terms of GDP and Employment
Naturally, employment may rise as the health of the economy improves. To produce more goods, companies and factories might hire more employees to meet the demand. With more individuals employed and gathering paychecks, more people have money to spend on such goods – increasing overall consumption. Sometimes, however, GDP can grow but not quick enough to create more jobs for those who are unemployed.²
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, only of the buyers and sellers and is not 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 all surged in the following months after the market downturn in March 2020. On the other hand, GDP decreased by five percent in 2020’s first quarter. It has since risen and steadied through 2021.
Jean Chatzky with hermoney.com stated, “Since 1970, U.S. economic growth has averaged 2.7% each year. During that same time period, the S&P 500 has seen average annual gains of about 8.7%.”
Why is there such a disconnect between the stock market and the economy? You can find three reasons below.
Reason #1: The Stock Market Isn’t Representative of All Who Make Up the U.S. Economy
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.
According to Chatzky, the stock market only has a pulse on what’s happening in the approximate 4,000 publicly traded companies available. Considering there are more than 23 million employers in the U.S., that is not a large enough sample size for the entire economy’s health.
Reason #2: The Stock Market May Not Display an Equal Distribution Between Those Who Make Up the Economy
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% of households in the United States were in control of 84% of the total value of stock shares, bonds, trusts, and business equity and over 80% 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 make up the economy as a whole.
Reason #3: Investors May Be Driven by Emotional Decision-Making
It’s long been understood that at times, investors may be driven by emotional decision-making. As a result, their behavior may not be mimicking the economy’s current state or actual affairs happening in real-time.
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. Considering other factors such as unemployment can provide a better depiction of the state of the economy and the people living in the U.S.
We hope this provides you with some direction when figuring the stock market and the economy into your financial plan. Do not hesitate to reach out with any questions or concerns. If you think Montage Wealth Management would be a good fit for your financial planning needs, please contact us at info@montagewm.com or call (585) 419-2270.
