How Does The Stock Market Represent Economy?

The stock market is a small part of an economy and it can be seen as a tool to raise capital for the companies. When utilised properly it can boost the economy of the country.

How Is the Stock Market Viewed?

Stock markets have been viewed as a “predictor” of the economy. Many people believe that a large decline in stock prices are reflective of a future recession, whereas substantial hike in prices suggests future economic growth. Stock market is correlated with the country’s economy, influenced by policy decisions of the country. It cannot be determined whether a short-term crash leads to a decline in the country’s economy.

Dichotomy?

The stock market crash of 1987 also referred to as “Black Monday” didn’t cause any long-lasting harm, though it influenced monetary policy and led United Kingdom to cut interest rate in fear of recession. In spite of it, low interest rate caused a boom. Whereas in the case of collapse of the London stock market in 1929, affected the economy and people of London, is one of the factors for 1930s depression.

How Does the Stock Market Really Impact the Economy

In case a company is in profits its share market value increases, which causes an increase in the flow of investment, leading to capital formation and increase in production. However, this leads to expansion creating high employment opportunities, increased shareholder wealth that leads to increase per capita income and increases the Gross Domestic Product.

Whereas in case a market collapses then the shareholders money gets evaporated, causing decline in his wealth, economic recession and many organisation can go bankrupt. This leads to economic depression.

As we know when economy expands the stock market will be bullish, while economy shrinks the stock market will be bearish. Such changes in the economy can be clearly seen in the performance of stock market of the country.

Example: This can be clearly observed during 2008 recession where world economy was in recession; stock markets around the world took a major hit where we saw sharp decline in stock indices, like in Indian indices – Nifty 50 saw a sharp decline of around 30 percent from 6,365 to 2,230. The graph below shows the impact of recession on nifty.

Not Always the Best Predictor

The graph above shows relation between GDP and Stock market with rise in GDP stock market also performs well. India has seen robust GDP growth since 2014 and its stock indices Nifty 50 has nearly grown twice from 5,600 to maximum of 11,700. But this may not always hold correct as stock market is only small portion of an economy.

Case of Chinese Stock Markets

But in some cases like that of China, its stock market remains in a falling mode despite the country’s intense economic growth. In 2004, China GDP accounted for 13.5 million yuan which was a 9.5% rise on a yearly basis; while the composite index of Shanghai stock dropped 15.15%. This goes on to show that in the shorter run stock market does not reflect the real picture of the economy. But the effects of changes in the economy are truly felt in stock market.

Various Opinions and Theories

As per the tenets of economic theory, a strong link between level of economic activity and stock prices is found under the conditions that the stock price is the result of sum of discounted present value of the firm’s future payouts.

The discounted cash flow model upholds the concept that stock prices are a harbinger of real economic activity. This is led by the belief that the approximations about the firm’s future payouts are correctly ascertained by the investors. This is one of the main theories and argument as to how stock and economy are inter-related. There are some theoretical models as to how stock prices and economy are directly linked:

• Link suggested by Tobin (1969): Its main focus lies on the impact of the share prices on the cost of capital. When share prices are high, the value of the firm relative to the replacement cost of its stock of capital is also high. Consequently, this leads to increased investment expenditure and thus higher aggregate economic output as firms find it easier to finance investment expenditure.
• Link suggested by Modigliani (1971):  Modigliani proposed a theory on the impact that the wealth variables have on consumption by public. Increase in stock prices results in an increase in the individual’s wealth holdings, and therefore higher income.
• Link suggested by Bernanke and Gertler (1989):  The channel focus on impact that stock prices have on firm’s balance sheet. Due to presence of asymmetric information in the credit market, the ability of firms to borrow depends substantially on the collateral they can pledge. The collateral value firm can offer increase in scenario where their stock price value increases. As the collateral they can offer increase, higher credit can be raised, which in turn can be used for investment purpose and thereby triggers an expansion in economic activity.

Of course, the most important correlation between stock and economy is of time. A shorter time frame shows a weak relationship. In a longer time frame spanning years and even decades, the performances of both phenomena will be parallel. The fact remains that stocks can move independently of the changes in the economy for a while, but at some point if there are significant fluctuations in the economy, stocks can behave haphazardly. Thus, it has been proven over and over again that buy-and-hold is the best strategy to survive in the stock market.