The price of a stock is seen as a reflection of the health and success of a company. Yet the state of the stock market as a whole is not as directly correlated to the success of the local economy. For example, prices affect consumer and business confidence, and the confidence of investors and company owners influence the overall market. How is the stock market connected to economic performance?
The Stock Market as a Barometer of Mood
The stock market and the economy influence each other, but the terms should not be used interchangeably. Prices typically follow a trend, and that doesn’t necessarily match other economic trends.
Yet the stock market’s trend line can influence the psychology of investors and the public in general. If the prices are going up, they may go up higher than the business fundamentals say it should be priced because people expect it to keep going. That can lead to a bubble, but it tends to lead to a correction. If people are afraid a market sector is going to suffer, they’ll sell off stocks and devalue them, though an individual company may be stable and profitable.
The overall stock market can be a barometer of collective mood as well. As the market trends upward, people tend to buy stocks that are appreciating. More importantly, others join the market hoping to profit from the upward trend. They may buy them in the mere hope that it will go up. And the inverse is true in a bear market, when the stock market is going down.
When people are pessimistic about the economy or about a particular industry, they’ll sell, and others will flee the market to sit on the sidelines. When the news media creates a climate of fear, people will move funds from the stock market to lower risk assets. That will depress stock prices further and make their predictions of doom and gloom come true. Sheer fear can cause a stock selloff and collapsing market though the businesses themselves are doing fine.
Volatility in the stock market is itself a sign of general uncertainty. In general, that hurts consumer and business confidence. It can be offset by other positive metrics like improving employment rates and gross domestic product growth. Trading price movements of shares up or down is possible via contracts for difference. This means you could profit from downward stock market trends in addition to the traditional method of buying them in the hope it can be sold for a profit later. For more information visit easymarkets.com.
The Stock Market as a Reflection of Consumer Spending
We’ve discussed how the stock market can be a reflection of general sentiment, accurate or not. The stock market can also be a reflection of consumer spending habits. When people increase their spending in a given area, stock prices in that industry will generally rise. When reports come out that people are losing interest in a company’s products or a class of products, the stock price for related companies will fall.
Stock markets can also drive consumer spending, since they’re a measure of consumer sentiment. For example, a rapidly appreciating stock portfolio makes many people feel wealthy. They’re now more likely to spend on consumer goods and big-ticket items.
When portfolio values are falling, they’re more likely to put off purchases or downshift their purchasing to cheaper products. This even affects the general economy. A falling stock market can cause people who don’t hold stock to cut back on nonessential spending as they beef up savings, just in case the economy slows down and they lose their jobs. In this regard, a falling stock market can cause slower economic growth.
The Stock Market and Business Investment
Issuing stock is one way in which companies can raise money to expand the business. Stock prices can also affect business investments. Businesses are more likely to invest in new capital improvements when there is strong, positive sentiment.
If people think things are going well and will spend more, this is the time to invest in new production and storefronts. And when the stock market is going down, companies tend to push pause on their expansion plans. They’re afraid a slowdown in consumer spending will hurt their business. Furthermore, the lower price of their stocks prevents them from issuing new stock to fund growth.
On the other hand, optimism explains why merger and acquisition activity speeds up during bull markets. When stock prices are high, the stock can be swapped as part of a merger because of its high value. This allows firms to essentially buy other firms without having to use as much or even any cash. And when business and consumer confidence is high, you see more initial public offerings, because firms expect to get the most money for their shares. This is why it’s important that you know everything you can about mergers and acquisitions. A perfect place to start would be this Wall Street Prep guide.
The Interest Rate and Stock Markets
Interest rates affect the economy, and this in turn has an effect on the stock market. When interest rates rise, borrowing costs go up. This will slow down consumer spending and business investment. When interest rates go down, this can stimulate economic growth because borrowing is cheaper.
However, interest rates may be a response to economic conditions that have their own impact on the stock market. For example, higher interest rates required to issue new debt to cover a major government spending deficit will slow down an economy and reflect trends that will hurt it long-term. Currency fluctuations that cause interest rates and currency values to go up will increase the cost of exports. This will hurt export-driven firms and countries with export driven economies.
The stock market can go down when interest rates go up, too. When the national economy is overheating, raising interest rates is a way to cool things down. This is a sign that inflation is a problem, since it was necessary to take action to adjust it.
Raising interest rates faster than expected demonstrates that there is a serious issue, and it can cause the stock market to drop. A national bank dropping interest rates repeatedly is also a warning sign. It demonstrates that the economy isn’t picking up as fast as the economic leaders think it should.
The stock market is affected by both business fundamentals and general sentiment. These two forces can be at odds with each other, but they can influence each other as well.