How Stock Market affects the economy

1. Raising Funds for Companies. Barclays recently announced a share issue to raise just under $9billion. This is to try and help the company survive the credit crunch and so it is important for the banking system, which currently needs more liquidity.

2. A place for investment.

Pension funds and investment trusts look for a variety of investment options. They will try to get a balanced portfolio to provide income and capital gains for their members. The stock market can traditionally offer a mix of interest (dividends) and capital growth over the longer term. Of course, the stock market is more risky, but, if investment trusts get it right they can offer an excellent return for their trust fund. People often forget how much dividends you can get from shares. For example Barclays currently offer a dividend equal to 11% of the share value – making it excellent value (assuming they don’t have to write off billions of bad debt in the near future)

3. Share Prices and affects on economy

Movements in the stock market can also affect the macro economy in long run. – How does stock market affect economy?

• Barclays share issue

If the company sells 10,000 shares at £1, then it receives £10,000 which it can use for investment. If the share price then fluctuates, it doesn’t change the initial sum the firm gained. For example, if the share price fell to 60p, the firm would still have the initial investment of £10,000. However, if the share price collapsed it would affect the company in some ways:

• Harder to issue a share rights issue to raise future capital (many banks are trying to do this at the moment)
• The firm may become subject to a take over, especially if the collapsing share price is due to bad management and other people think they can run the company better.
• Also, it is worth bearing in mind that a collapsing share price is often a reflection of a badly performing firm – a firm which is making a loss. It is not the other way around ie. it is not that a fall in share prices will cause a firm to become unprofitable and inefficient.

With share prices falling significantly since the start of the year, it is an interesting question to consider what is the economic impact of this.

• Lower Share prices mean investors will see a fall in wealth. However, this is unlikely to influence consumption significantly. Most people who buy shares are relatively affluent; if their stocks decrease in value it doesn’t mean their consumption will suffer. Usually, people who buy shares see it as speculative investment.
• Nevertheless, if the fall in shares is prolonged it will have a small effect in reducing consumer spending.
• In the long term, lower share prices will harm investment trusts and pension funds. This could leave people with lower pension payouts. However, this is very much a long term factor.
• More difficult to raise finance for investment. Some firms use the stock market as a way to raise finance for investment. If share prices fall, it will be more difficult to raise equity through share issues and so it could reduce investment. However, this is only a relatively small influence on investment levels.
• Confidence Factor. Falling shares may weaken consumer and business confidence; it reinforces the economic turmoil and may make them reluctant to spend and invest.

Conclusion

• Falling share prices are primarily a reflection of a weakening economy in the US and UK. It is not the share prices that are causing the economy to go down.
• If banks like Bear Sterns went bankrupt that would have a big economic impact.
• Sometimes falling share prices can occur even during high growth. The stock market crash of 1987 was followed by an economic boom in the UK
• My prediction is that share prices may recover in the later part of 2008, but the US will still go into recession. The recession is already built into share prices.

Related

• How does stock market effect economy?

There is a saying: stock markets have predicted 10 out of the last 3 recessions.

With plummeting share prices making headline news, it is worth considering the impact of the Stock market on the economy. How much should we worry when share prices fall? How does it impact on the average consumer? and how does it affect the economy?

Economic Effects of Stock Market

1. Wealth Effect

The first impact is that people with shares will see a fall in their wealth. If the fall is significant it will affect their financial outlook. If they are losing money on shares they will be more hesitant to spend money; this can contribute to a fall in consumer spending. However, the effect should not be given too much importance. Often people who buy shares are prepared to lose money; their spending patterns are usually independent of share prices, especially for short term losses.

2. Effect on Pensions

Anybody with a private pension or investment trust will be affected by the stock market, at least indirectly. Pension funds invest a significant part of their funds on the stock market. Therefore, if there is a serious fall in share prices, it reduces the value of pension funds. This means that future pension payouts will be lower. If share prices fall too much, pension funds can struggle to meet their promises. The important thing is the long term movements in the share prices. If share prices fall for a long time then it will definitely affect pension funds and future payouts.

3. Confidence

Often share price movements are reflections of what is happening in the economy. E.g. recent falls are based on fears of a US recession and global slowdown. However, the stock market itself can affect consumer confidence. Bad headlines of falling share prices are another factor which discourage people from spending. On its own it may not have much effect, but combined with falling house prices, share prices can be a discouraging factor.

4. Investment

Falling share prices can hamper firms ability to raise finance on the stock market. Firms who are expanding and wish to borrow often do so by issuing more shares – it provides a low cost way of borrowing more money. However, with falling share prices it becomes much more difficult.

As I said earlier there is an oft repeated quote saying the stock market has predicted 10 out of the last 3 recessions. The point is that falling stock markets do not necessarily predict the economic future. Share prices can fall without causing a downturn in the economy. For example, one thinks of the stock market crashes of October 1987; there wasn’t an obvious economic factor causing this share price fall. The major economies remained relatively unaffected by this stock market crash. In fact, the UK had record growth in the late 1980s. This time the stock market fall is due to economic weaknesses so is a better guide to future economic performance.

• Essays on Recessions
• Will a Stock Market Crash cause a depression?

Although, mortgage defaults in the UK are not such a problem in the UK. The UK is been squeezed by the shortage of capital as investors are unwilling to risk purchasing any ’subprime’ related debt. This has caused the cost of borrowing to increase, it means that mortgage costs have increased despite the cut in interest rates.

What Factors Will Affect the Stock Market in the Coming Year

1. Slowdown in Growth. A slowdown in growth is now widely expected. Lower growth will lead to smaller profits and therefore lower earning this will have a negative impact on share prices. However, the lower growth is probably already built into the share prices. Often stock markets can do surprisingly well in recessions – usually because the stock market anticipates the falling growth
2. Cut in Interest Rates. Lower interest rates are usually welcomed by the city. Falling interest rates make the stock market relatively more attractive than the bond market. Lower interest rates will also boost growth and stave off any recessionary threat.
3. How Bad will the Credit Crisis Become.  A key factor in determining the performance of the stock market will be how deep and severe the credit crisis becomes. It may be that the US government approve a rescue practice for mortgages at risk of defaulting. If the US housing market stabilises then confidence may return. If this occurs it will provide a big fillip for the stock markets.

Which is Best Stock Market to Invest In.

If you are unimpressed be prospects for the FTSE-100 or Dow Jones in US, you might be better off investing abroad. The Indian Sensex has offered good returns in recent years, some analysts suggest that the potential of the Indian economy means it has a long way further to go.

• List of FTSE-100 Companies
  
• Top 10 British Companies
• FT-30 All Share

Readers Question: The question is that how did a flawed capitalism of the 1920’s American economy lead to the 1929’s stock market crash?

The 1929 Stock Market crash was a result of various economic imbalances and structural failings. These are some of the most significant economic factors behind the stock market crash of 1929.

Agricultural Recession.

Even before 1929, the American agricultural sector was struggling to maintain profitability. Many small farmers were driven out of business because they could not compete in the new economic climate. Better technology was increasing supply. But, demand for food was not increasing at same rate. Therefore, prices fell and farmers incomes dropped. There was occupational and geographical immobilities in this sector. It was difficult for unemployed famers to get jobs elsewhere in the economy.

Boom and Bust.

A lot of the Stock Market crash can be blamed on over exuberance and false expectations. In the years leading up to 1929, the stock market offered the potential for making huge gains in wealth. It was the new gold rush. People bought shares with the expectations of making more money. As share prices rose, people started to borrow money to invest in the stock market. The market got caught up in a speculative bubble. – Shares kept rising and people felt they would continue to do so. The problem was that stock prices became divorced from the real potential earnings of the share prices. Prices were not being driven by economic fundamentals but the optimism / exuberance of investors.

This was not the first investment bubble, nor was it the last. Most recently we saw a similar phenomena in the dot com bubble. Here, the effects were much less because it was confined to a small sector of the stock market.
The weakness of capitalism is people’s irrationality. i.e. people stopped judging shares on economic potential, but, got caught up in a speculative bubble.
Therefore, in October 1929, Shares were grossly overvalued. When some companies posted disappointing results, some investors started to feel this would be a good time to cash in on their profits. This initial selling caused a fall in prices; this change in market sentiment soon spread as other investors started to panic and follow suit. Before long the market was falling very rapidly. The bull market had been replaced by a bear market.

Mismatch between production and consumption

The 1920s saw great strides in production techniques, especially in industries like automobiles. The production line enable economies of scale and great increases in production. However, demand for buying expensive cars and consumer goods were struggling to keep up. Therefore, towards the end of the 1920s many firms were struggling to sell all their production. This caused some of the disappointing profit results which precipitated falls in share prices.

Inequality

One reason why consumption struggled to match production was that the benefits of economic growth were not equally distributed. The majority of Americans still earnt less than $2000 per year. Wealth was inequitably distributed.

Weaknesses in the Banking System

Before the Great Depression, the American banking system was characterised by having many small to medium sized firms. America had over 30,000 banks. The effect of this was that they were prone to going bankrupt if there was a run on deposits. In particular, many banks in rural areas went bankrupt due to the agricultural recession. This had a negative impact on the rest of the financial industry.Between 1923 and 1930 5,000 banks collapsed

Note: If the question was – What Caused the Great Depression? the answer would be slightly different. This is because some believe the Stock market crash was only partly to blame for the Great Depression (although a significant factor in precipitating it.)

Related 

• Economics of the 1920s at Economics Help
  
• Causes Wall Street Crash
• Wall Street Crash – wikipedia