The stock market is an excellent economic indicator for the U.S. economy. It reflects how well all listed companies are doing. If investors are confident, they will buy stocks, stock mutual funds, or stock options. Some experts believe markets predict what the savviest investors think the economy will be doing in about six months.
What Makes the U.S. Stock Market Attractive
U.S. financial markets are very sophisticated and make it easier to take a company public than in other countries. Information on companies is also easy to obtain. That raises the trust of investors from around the world. As a result, the U.S. stock market attracts the most investors. It’s an attractive place for U.S. companies to go when they are ready to grow.
Three Ways the Stock Market Affects the Economy
Stock markets affect the economy in three critical ways.
Markets Allow Small Investors to Invest in the Economy
Stocks allow the individual investor to own part of a successful company. Without stock markets, only large private equity investors and financial institutions could profit from America's free market economy.
Markets Help Savers Beat Inflation
Investing in the stock market helps savers beat inflation over time. The rule of thumb is that stock prices increase 7% a year on average after taking inflation into account. That's enough to compensate most investors for the additional risk of owning stocks rather than bonds (or keeping the money in a savings account).
Markets Help Businesses Fund Growth
Growing, successful businesses need capital to fund growth and the stock market is a key source. In order to raise money this way, owners must sell part of the company, and to do so they "take the company public" through an initial public offering (IPO) of the company's shares. An IPO raises a lot of cash. It also signals that the firm is successful enough to afford the IPO process. The drawback is that the founders no longer own the company; the stockholders do. Founders can retain a controlling interest in the company if they own 51% of the shares.
Stocks indicate how valuable investors think a company is. When stock prices rise, it means investors believe earnings will improve. Falling stock prices mean investors have lost confidence in the company's ability to profit.
How a Stock Market Crash Affects the Economy
Stock prices rise in the expansion phase of the business cycle. Since the stock market is a vote of confidence, a crash can devastate economic growth. Lower stock prices mean less wealth for businesses, pension funds, and individual investors. Companies can't get as much funding for operations and expansion.
When retirement fund values fall, it reduces consumer spending. A stock market crash will adversely affect the nation’s gross domestic product as personal consumption and business investment are some of the major components of GDP.
If stock prices stay depressed long enough, new businesses can't get funds to grow. Companies that had invested their cash in stocks won't have enough to pay employees, or fund pension plans. Older workers may find they don't have enough money to retire.
The Stock Market Is Not the Economy
Despite its critical role in the economy, the stock market is not the same as the economy. The stock market is driven by the emotions of investors. They can exhibit irrational exuberance. It occurs during an asset bubble and the peak of the business cycle. They become overly optimistic even though there is no hard data to support it. The peak occurs right before a crash.
Investors confused the stock market and the economy during the Roaring Twenties. They didn't realize a recession had begun in August 1929. They kept driving stocks higher until the October 1929 market crash. Many other factors caused the Great Depression. The depression ended in 1939. But the stock market didn't recover until the 1950s.