The stock market is not the economy

BBecause the companies that make up the stock market represent trillions of dollars in investment, employ millions of people, and grab headlines, it’s easy to believe that the stock market and the economy are essentially the same.

When the stock market is up, you can infer that the economy is doing better. Similarly, when the stock market is down, you can infer that the overall economy is doing worse.

Such beliefs could be wrong.

Although the two are interrelated, they have key differences.

  1. Period of time. Note that economic measures relate to the past and can lead closely to the present. Meanwhile, the stock market is considered to be forward-looking, meaning that some investors believe it can anticipate economic conditions that may arise in the future.
  2. Cut. While the size of the US economy exceeds $21 trillion, the stock market (here we use the S&P 500, SPY, as an indicator) is currently worth around $40 trillion, almost twice as large. However, the stock market value can fluctuate considerably. During a downturn, the value of the stock market can converge roughly to the size of the overall economy. Renowned investor Warren Buffett uses a market capitalization to GDP ratio, called the “Buffett indicator”, to assess whether a market is overvalued or undervalued.
  3. How they are measured. The two entities belong to completely different categories. The stock market is measured at a specific *point* in time. For example, 4:30 p.m., January 4, 2021. The other – the economy – is measured during a particular *interval* of time. For example, from January 1 to December 31 of the year 2021. This distinction is commonly referred to as the distinction between a stock (not to be confused with the stocks that make up a stock market) and a stream.
  4. Growth vs returns. It is also important to remember that GDP growth does not necessarily correspond to positive stock market returns. While the two can go hand in hand, there are instances where the two have diverged. Some years the stock market rose while GDP growth was negative, while other years the stock market fell while GDP growth was positive. In fact, there may be little correlation between GDP growth and stock market returns.

Here are some statistics that highlight the difference between the companies that make up the S&P 500 and the overall economy.

  1. Number of employees. In 2022, the entire United States had more than 155 million people employed; S&P 500 companies employ about ~⅙ of that number.
  2. Number of companies. As the name suggests, the S&P 500 (SPY) is made up of 500 companies, while overall there are thousands of publicly traded companies; just under 4,000 are listed on major US stock exchanges. Including unlisted companies, there are over 30 million businesses (~8 million sole proprietorships) in the United States, so publicly traded companies represent a small percentage of the total number of companies. Also note that the overall economy includes both the private * and * public sectors, with the private sector accounting for about 80% of the economy.
  3. Revenue. Note that market cap is a multiple of the annual revenue generated (or projected) by companies in that market. Currently, the stock market (S&P 500) is trading at over 3x Price/Sales, implying that the revenue generated by S&P 500 companies is over $10,000,000. Again, compare that to US annual GDP ~$21,000, or almost 2x.

Because companies in the S&P 500 (or any stock market index) are part of a subset of the overall economy, trends in that subset may eventually diverge from the rest of the economy.

Consider a scenario in which S&P 500 companies gain market share at the expense of smaller, non-index companies. In this scenario, S&P 500 companies could perform better than the economy as a whole.

More importantly, as noted above, the economy and the stock market can sometimes decouple. When the economy is doing poorly, for example during a recession, stock markets can sometimes rebound.

How can this be? It is important to understand that the stock market is looking to the future. In the opinion of some investors, the stock market actually serves as a leading indicator of the economy.

This means that the stock market *anticipates* improving conditions, sometimes months before conditions actually start to improve.

And in times when the economy is doing well, the stock market can, in theory, underperform. Indeed, the market anticipates problems and a slowdown in growth.

So, just as you do with earnings reports and individual companies, look to macro-related headlines to provide clues about the future of the overall economy.

And, as professional investors do, look at the reactions of the stock market and the stock industry – in the short to medium term – as these can also provide clues about the underlying economy.

You can find news and information about the S&P 500 under the symbol SPY and other similar indices on our Tornado platform.

Originally posted on Tornado.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.