The stock market and the economy of a country are two terms mentioned all the time in the world of money. But what are these terms and how are they related to each other?
The stock market refers to the collection of exchanges where regular activities of buying, selling, and issuance of shares of publicly-held companies take place. An economy is the large set of inter-related production, consumption, and exchange activities that aid in determining how scarce resources are allocated. The production, consumption, and distribution of goods and services are used to fulfill the needs of those living and operating within the economy, which is also referred to as an economic system.
Generally, the stock market reflects the economic conditions of a country’s economy. If an economy is growing then output will be increasing and firms should be experiencing increased profitability. This higher profit makes the company shares more attractive, because they can give bigger dividends to shareholders. A long period of economic growth will tend to benefit shares of the companies as investors do not fear a recession happening. Just like the stock market and the economy grow together, it also falls together. If a country’s economy is forecasted to enter into a recession, then its stock markets will fall. This happens because a recession means lower profits, reduced dividends and even the chances of companies going bankrupt, which would be bad news for shareholders. During this time of chaos, investors try to avoid shares, because of the greater risk involved in it.
Many times, when recessions are merely predicted to happen, the stock market crashes for weeks or even months at a stretch, even if the predictions were found to be false afterwards. Company shares can rise and fall irrespective of how the economy is doing. For instance, if investors think a company’s share price is over-valued or if a company’s good management is removed and replaced with a bad one, then shareholders sell the stocks, resulting in the fall of the firm in the stock market. Whereas, if a company announces a new innovative product, then more people invest in that company hoping to get a piece of the profit the firm will make, thus causing the shares to rise.
There are cases when a country is in a long recession, but the stock market, after a fall in the initial days or weeks, seem to recover and grow despite the fallen economy. For instance, during the 2008 recession, the stock market did take a big hit along with the economy. But while the country is still recovering at a very slow rate after more than a decade since the economic crisis, the stock market has had one of its best decades, with number of companies reaching new heights of glory, and even a handful of firms entering trillion-dollar valuations. Despite relatively weak economic growth, companies such as Apple, Google, Amazon and Microsoft, are still attractive to shareholders because they have retained their profitability, and showed a faster growth rate than the GDP of the country they are operating in.
In conclusion, there is an increasing divergence between the stock market and the economy. How good or bad the economy is doing has much less impact on the stock market today than it did 10 or 20 years ago.
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