The stock market affects individual businesses in the economy in many different ways. There are nearly 4,000 publicly traded stocks in the United States, which can be roughly divided into 11 Global Industry Classifications (GICS). With daily movements across the board, there can be many effects.
Many analysts often focus on the S&P 500 as a barometer for overall market performance and as such one of the most influential drivers. Here we look at the two most fundamental influences on businesses: 1) consumer spending and 2) business operations.
Stock market and economy
Defined as the market in which shares of publicly traded companies are bought and sold, the stock market measures the aggregate value of all publicly traded companies. In aggregate, this may be represented by the Wilshire 5000, but in general, most analysts and investors focus on the S&P 500. Both indexes can be valuable tools for measuring the health of the entire economy, even if stocks can be misleading at times.
The stock market and economic performance are usually aligned. So when the stock market does well, it’s usually a function of a growing economy. Economic growth can be measured in several ways, but one of the most prominent is by tracking gross domestic product (GDP).
When GDP increases, individual businesses produce more and usually expand. Expanding trading activity usually increases valuations and leads to gains in the stock market.
Historically steep market declines preceded the Great Depression of the 1930s as well as the Great Recession of 2007-2009. However, some market crashes, the most famous of which was Black Monday in 1987, were not followed by recessions.
Stock market and consumer spending
Consumers often spend more during bull markets because they earn more from the effects of a strong economy and also feel richer when they see their portfolios increase in value. During bear markets, the economy usually does not do well, and spending declines. The current decline in stock values also creates fear of loss of wealth and purchasing power as the value of investments declines.
A rising stock market is usually associated with a growing economy and leads to greater investor confidence. Investor confidence in stocks leads to more buying activity, which can also help push prices higher. When stocks go up, people who invested in stock markets gain wealth. This increase in wealth often leads to increased consumer spending, as consumers buy more goods and services when they are confident that they are in a financial position to do so. When consumers buy more, the businesses that sell those goods and services decide to produce more and sell more, benefiting in the form of increased revenue.
Stock market losses erode wealth in personal and retirement portfolios. A consumer who sees a decline in the value of their portfolio is likely to spend less. This reduction in spending negatively affects businesses—especially those that sell unnecessary goods and services, such as luxury cars and entertainment, that customers can do without when money is tight.
Stock exchange and trading operations
Movements in the stock market can affect companies in a variety of ways. The rise and fall of stock prices affect a company’s market capitalization and thus its market value. The higher the stock prices, the higher the market value of the company, and vice versa. A company’s market value can be important when considering mergers and/or acquisitions that include stock as part of the deal.
The decision to issue shares can also be influenced by stock performance. If the stock is doing well, the company may be more inclined to issue more shares because they believe it can get more capital at a higher value.
The stock market performance also affects a company’s cost of capital. Companies must average their cost of debt and equity capital to arrive at a weighted average cost of capital that is used for many analytical scenarios. The higher the expected market performance, the higher the cost of equity capital will be. As the cost of equity increases, present value calculations decrease because companies must use a higher discount rate.
Companies may also have significant equity investments in their stock, which can lead to problems if the stock falls. For example, companies may hold shares as cash equivalents or use shares as collateral for pension funds. In any case, when the stock goes down, the value goes down, which can lead to financing problems.
Finally, a positive increase in stock value can also potentially generate new interest for a particular company or sector. This may eventually contribute to the growth of sales revenue or attract investors.
Many say that the stock market is the backbone and reflection of a country’s economic progress. Others believe that movements in any stock market trigger psychological changes by alerting businesses to their need to either shrink or expand. Some economists also believe that a crashing stock market is hurting consumer spending. This in turn causes a slowdown in economic growth. As the famous economist Joan Robinson once so aptly observed, “When five economists discuss the impact of the stock market on the economy, they end up with six opinions.”
Below are the reasons why the stock market leads the economy and is a reflection of its true performance:
Stock market activities influence the monetary policy of the country’s top bank and the expansion of the country’s gross domestic product (GDP).
The stock market, which has been largely bullish in its activities, will generally influence economic policymakers to raise interest rates. However, it is also worth noting that stocks tend to underperform during periods marked by restrictive monetary policies. This results in spiraling stock indexes that provoke the government to tighten cash outflows, ultimately leading to a pullback in the stock market.
Employment factor
Employment, which is the main indicator of a country’s economic progress, has a profound impact on both stock and bond markets, especially in the area of one-day movements when the country’s monthly employment and unemployment statistics are announced. The employment situation also affects consumer sentiment and consumer confidence, which in turn is reflected in market performance.
The state of the labor market largely affects the well-being of the economy. In other words, this means that a weak labor market can lead to lower corporate profits. This is based on the assumption that as unemployment rises, people are unable to invest in homes or indulge in the necessary purchases that are responsible for driving corporate profits.
Inflation determines the movement of the stock market
The Reserve Bank of India promotes and monitors the price stability and economic growth of the country. Price stability can be measured using the rate of change in inflation, which has a substantial impact on the RBI’s monthly monetary policy. The CPI, or Consumer Price Index, is the main indicator of inflation and measures changes in the prices of consumer goods. It is a measure for determining the increase in the cost of living, the brunt of which must be borne by the average consumer.
In addition to economic indicators, investor activity indicators are a big market guide for participants. Contrary to popular belief, it is a bearish situation that is ideal for investment and not a bullish one. The latter increases prices and makes analysis of investor sentiment mandatory. As NRI investment in India continues to grow and the central bank buys more government bonds, interest rates often fall, pushing stock prices higher. Conversely, less buying with high-interest rates depresses stock prices. It is also prudent to note market indicators such as decline/advance ratios as well as the total number of highs and lows recorded by the market. These show the overall state of the stock market and confirm the “quality” of the stock market’s progress or decline.
In short, identifying those market and economic indicators that move the markets is only the basis of the exercise. The real trick is to interpret how these indicators affect the market. In addition, the trends of the indicators should be taken into account, as well as what the market expects from the indicator.
Image Source: Semantic Scholar
Also Read: What is Stock Market, History of its beginning, How does it Work?
