It would be rational to think that there is a relationship between the economy and the stock market. If the economy is performing well, then it could be assumed that economic growth would enhance the profitability of a company and hence improve their stock price. In a recession, companies can encounter lower profits. This may mean reduced dividends for stockholders and a falling share price. There have been numerous studies on this argument. Stock prices change rapidly and can be affected by reasons which are independent from factors which influence the economy.
These are the reasons why there is often no link between the economy and stock market returns.
Supply and demand
Stock markets fluctuate all the time and do not reflect what is happening in the economy. The price of a stock depends on supply and demand. Investors determine the price they would like to buy and sell the stock. Demand for a stock is determined by the investors view of the company and not how the economy is.
Stock markets are forward looking
Stock prices may factor in future transactions. Markets have performed well during a recession as investors anticipate companies performing well in the future. Prices can incorporate the company’s future growth potential. Usually the stock market does poorly before the recession and by the time the recession hits, it is already recovering.
The stock market is made up of buyer and sellers who can make emotional decisions which can cause the stock prices to deviate away from the company’s intrinsic value. Therefore, stock prices may not reflect the actual earning capacity of a company but rather than the price an investor is willing to buy and sell.
Effect of low interest rates
Low interest rates have affected the stock market by creating high asset values. With low interest rates, companies can borrow more and expand their business with easier accessibility to debt. Hence low interest rates can inflate stock prices and does not necessarily mean the economy is strong.
The stock market does not reflect what is happening in the private sector. The stock market only monitors publicly listed companies. Australia has about 1.6 million companies and most are private companies. Just a little over 2000 companies are listed on the exchange. The stock market is only a small representation on how companies in Australia are performing.
News and media
Stock prices are significantly affected by the press. Scandals involving CEOs can negatively affect a company but these have no effect on the economy. This strengthens the argument that stock prices can change rapidly and can be affected factors that have no bearing on the economy.
The unemployment rate
One of the indicators used to assess the health of the economy is the unemployment rate. The stock market does not measure the level of unemployment or underemployment in the economy
The stock market consists of companies that have operations abroad. The fluctuation of prices for these companies may be affected by what is happening in those overseas markets as opposed to the domestic market.
The stock market does not reduce national debt
A higher stock market can mean higher company profits which benefit shareholders but this does not reduce the debt for the country.
Lauren Hua is a private client adviser at Fairmont Equities.
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