Relationship Between Stock Market and Economy

May 30th, 2008 | economics -

Readers Question: Here’s my question. What’s the relationship between a countries economy and it’s stock market? Is it always true that the stock market reflects a country’s economic conditions.

Generally speaking, the stock market will reflect the economic conditions of an economy. If an economy is growing then output will be increasing and most firms should be experiencing increased profitability. This higher profit makes the company shares more attractive – they can give bigger dividends to shareholders.

If the economy is forecast to enter into a recession, then stock markets will generally fall. This is because a recession means lower profits, less dividends and even the prospect of firms going bankrupt, which would be disastrous for shareholders.

However, in a recession, stock markets can sometimes increase, why is this? Often this is because stock markets are forward looking. The stock market has probablyh already priced in the effect of the recession and now the stock market is anticipitating a recovery. For example, stock markets in 2007 and 2008 performed badly in anticipation of a US recession.

Stock Markets and Developing Economies.

If you have a country with a consistently higher rate of economic growth, then generally stock markets will perform better than in a country with lower rates of growth. The link may not be perfect but there definitely is some potential. For example, the Indian stock market has done well in the past couple of years and Indian economic growth has increased

When the Stock Market Can Affect the Economy

In some situations you can argue that the stock market can actually affect the economy. The best case would perhaps be the Wall Street Crash of 1929-32. This rapid decline in the stock markets severly affected business and consumer confidence. It also caused banks to lose money. This crash was undoubtedly a factor in contributing to the length and severity of the Great Depression. Having said that, it is also worth pointing out that the stock market crash was due to the prospect of recession. In a way the falling stock market and depression were closely linked.

Stock Market doesn’t always affect the economy. On black Monday 1987 stock markets around the world crashed. However, this didn’t precipitate a recession like previous stock market crashes