There has and continues to be extensive research on the effects of the stock market on a country’s economy. The following are the reasons why the stock market leads the economy.
Many say the stock market is the backbone and reflector of a country’s economic progress. Others opine that the movements of any stock market trigger psychological changes by alerting businesses about their need to either downsize or expand. Some economists also believe that a crashing stock market impairs consumer spending. This in turn, causes decelerated economic growth. As the celebrated economist, Joan Robinson once so aptly remarked, “When five economists discuss the impact of the stock market on the economy, they end up with six opinions.”
The following are the reasons why the stock market leads the economy and is a reflector of its actual performance:
The Employment Factor
Employment being a major indicator of a country’s economic progress, has a profound impact on both stock and bond markets particularly in the sphere of one-day movements when a country’s monthly employment and unemployment statistics are announced. The employment situation also influences consumer sentiment and consumer confidence, which again reflect on the market’s performance.
It goes without saying that the labour market’s state influences the economy’s well-being to a great extent. This in other words, implies that a weak labour market may result in lesser corporate profits. This based on the premise that with rising unemployment, people are unable to invest in homes or indulge in necessary purchases responsible for driving corporate profits.
Inflation Determines Stock Market Movement
The Reserve Bank of India promotes and monitors price stability and the country’s economic growth. Price stability can be measured in terms of the rate of inflation change and this has a substantial influence on the RBI’s monthly monetary policies. The CPI or Consumer Price Index is the chief indicator of inflation and measures changes in prices of consumer items. It is a gauge for determining the increase in living expenses, the brunt of which has to be borne by average consumers.
The PPI or Producer Price Index measures inflationary changes in the prices of producer goods. Should these keep increasing substantially, manufacturers are most likely to pass on this price increase to consumers and consequently affect their behaviour. Fluctuations in oil prices globally too, have a significant impact on the global economy since oil is a key principal indicator of economic progress and activity. Sudden increases in oil prices usually have negative effects on most economies that are dependent on it. Increased oil prices accelerate the prices of numerous consumer goods because of the higher costs of their transportation.
Inflation can also be a key metric for corporate valuation. This is because the higher the inflation, the higher is the discount rate and lower the project value. Alternately, deflation too, is dangerous as it leads to decreased revenue and layoffs in future for firms unable to maintain full workforces. Lower corporate valuation, therefore has a negative impact on stock markets globally.
Effects of Consumer Activity
Sharp changes in consumer activity directly impact corporate profits and thus, stock prices. consumer confidence here is a notable factor because the confident consumer spends more. When markets are on the rise, stock prices usually reflect the consumer’s future opinions. Moreover, increased consumer confidence leads to higher retail sales and encouraging shopping patterns. The consumer who has a disposable income is also most likely to invest in real estate, particularly housing, which again is a major economic indicator. Available data from the real estate sector help market participants to deduce whether people are game to make heavy investments in real estate or not.
Economic indicators apart, investor activity measures are grand market clues for participants. Contrary to popular belief, it’s the bearish situation that is ideal for making investments and not bullish conditions. The latter drives prices higher and makes analysis of investors’ sentiment mandatory. As NRI investments continue to grow in India, and the central bank buys more treasuries, the interest rates often slip and this pushes stock prices higher. Less buying on the contrary, with high interest rates, depress stock prices. It is also prudent to take note of market indicators like decline/ advance ratios as also the total number of highs and lows recorded by the market. These indicate the overall health of the stock market and provide confirmation on the “quality” of the stock market’s progress or decline.
In sum, identifying those market and economic indicators that actually move markets is the foundation of the exercise only. The actual trick is to interpret how these indicators impact the market. Additionally, indicator trends as also what the market expects from that indicator need to be taken into account also.