When we think of financial health, a few things might come to mind. We may think of our own financial status, our investments, the S&P 500 performance, the stock market as a whole, the economy, the country’s employment status and so on. While some aspects may be interrelated on some level, 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 each other. However, the stock market does not define economic health as a whole. As we’ve seen with COVID-19, stocks are back on the rise, but many individuals - and the world as a whole - are 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.
At the Heart of it:
When you really boil it down, the economy is backward looking. The stock market is forward looking. Nearly all economic indicators of how the economy are doing cannot be assessed in real time. They're published, often months after the data is collected, and then people react. So it's easy to look at GDP numbers being horrible (as an annualized rate GDP fell 8.2% in Q1 2020 in Canada, and 5% in the US).1 and imagine that the world is coming to an end. However, that GDP number was published at the end of May for Q1, which ended at the end of March, a 2 month lag. So is the data even still relevant or could the economy be recovering already? I don't have a crystal ball but how you approach this question is meaningful when you're reviewing the data or hearing it published on news sources. The stock market however is forward looking. Investors are trying to figure out what will happen in the future and are jostling to buy or sell assets depending on that appraisal of future opportunity. To it's entirely possible that the economic numbers could looks horrible from two months ago, and the potential opportunity could look amazing a few months in the future, and thus you get an enormous gap between the investment markets and the economy.
Eventually, the two will converge. Will the economy climb to mean expectations in the markets? Will the markets decline because expectations are not realized? I would argue no one really knows, and it's a fools errand to guess, especially as an individual investor with no special market access or unique information. The only information you really have is your own gut feeling, and we know that emotions are no way to invest.
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.”2 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.3
Economic Health in Terms of GDP and Employment
Naturally, employment may rise as production and consumption increase. To produce more goods, companies and factories might hire more employees to complete such production. With more individuals employed and gathering pay cheques, 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.3
What Is the Stock Market?
The stock market can be defined simply as “a stock exchange.”4 It is the buying and selling of ownership shares in a corporation.5 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) and of course the S&P/TSX Composite in Canada.6
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, TSX, the DJIA and the Nasdaq Composite index all have surged since the market downturn in March.7 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 in the US, and Canada follows.8,9 Why is there such a disconnect? A few reasons below.
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.
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 were 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 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.10
It’s long been understood that at times, investors may be driven by emotional or reaction decision-making. As a result, their behaviour 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, 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 fuller depiction of the state of the economy and the financial well-being of its residents.
This content is developed from sources believed to be providing accurate information. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.