The disparity between the Economy and the Stock Market

If you have been following the financial markets recently, you have probably observed one particular fact. The fact that while the world economy has shown signs of recession across the board, the financial markets, in particular the stock market, have not. On the contrary, they showed an extremely fast recovery and even reached historic highs.

Anyone who has been following the financial markets recently has most likely noticed a curious trend. Although the world economy has shown signs of recession, the financial markets, namely the stock market, are not following the same trend. On the contrary, they even show an extremely fast recovery, reaching historic highs in the values of their indexes.

And you wonder why this is happening? The main reason is a simple fact that the economy and the stock market are not the same. The health of an economy is measured through data from a country or region as a whole, data such as unemployment, exports, consumption, production, and the respective evolution of these factors. On the other hand, the stock market is where shares of companies are traded, and is measured through indexes, which take into account certain types of companies, which are divided by sector or size, indexes that show the average of the aggregate value as it rises or falls.

The essential point for understanding these different trends is the notion that we are dealing with two terms that, although extremely interconnected, are quite differentiable concepts.

Three major differences to consider

  • Distinct ecosystems – The pulse of an economy can be measured using data from a country or region as a whole. The indicators can be rates such as unemployment, exports, consumption, production, and the respective evolution of these rates. On the other hand, to get a sense of the direction of the stock market, and the environment where shares of companies are traded, we can do this through indices. Indices are composed of companies, which in turn can be grouped by size or sector. These indices represent the average of the aggregate value of the companies, depending on whether they rise or fall on the stock market. So, when we see that the well-known S&P500 Index, which represents the 500 largest American companies, is at historic highs, we cannot assume that it represents the country’s economy. It only represents the average “health” of the companies that make up the index. It is wrong to associate that value with an improving or deteriorating economy because it only represents that set of companies. However, the economy would not be restricted to only certain sectors or companies, it would encompass all companies, trades, households, and workers in the country.
  • Different time periods – While the economy is analyzed based on past, year-on-year data for indicators such as export rates, employment, or inflation, stocks are valued according to investors’ expectations of possible future earnings. So the Economy is a concept measured by comparisons with the past, and the Stock Market as a concept based on the analysis of forecasts of future performance.
  • The impact of companies – Considering the previous points we can easily agree that the weight of companies influences differently these two concepts of economy and the stock market. If by Economy we mean the globality of values referring to the GDP, production, consumption, services, and by the stock market, we assume only to be composed of companies, consequently, the oscillation of a company’s value will have a more significant impact on the stock market than on the Economy, which is composed by the stock market, but not only. The biggest drivers of the indexes have been technology companies such as Facebook, Netflix, and Amazon, which have performed well thanks to the pandemic context that motivates their use, as have E-commerce oriented companies. This small group of companies, by standing out notably from their peers, has helped climb the index values to historic highs.

Conclusion

The Economy and the Stock Market are extremely complex and interconnected entities, so it is not surprising that one influences the other, and that in the long run, they head in the same direction. From the point of view of an analysis of the current context, given that we are facing a crisis, their trends are different because their domains are also different.

The economy is given a macro scope in the sense that it fits the analysis through the comparison of global and past data with present data, and the Stock Market has its scope reduced to the comparison of index values on the forecast of future expectations.

Taking into account what is going on today we can think about the relationship between positive expectations about mass vaccination and the achievement of immunity, which has made stock values reflect strong performances in the stock market, in the face of a world economy that is facing serious problems with trades in crisis, high unemployment rates, and unquestionable losses in credit recovery.

That said, one begins to understand why the economy and the stock market diverge.

Visit the Disclaimer for more information.