Why Is the Stock Market Important to the Economy?

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The stock market, especially in the United States, is a key component of the economy on a number of scales: It can affect everything from individual finances to corporations, to the national economy and even to the global economic stage. In order to understand how the state of the stock market affects the economy, it’s important to first understand what the stock market is, what it does and how changes on this broad scale can impact what individual investors see doing their daily business.

TL;DR (Too Long; Didn't Read)

When stocks are increasing in value, there tends to be a great deal of optimism surrounding the economy. It shows the public that companies are capable of making money.

Stock Market Concepts

A stock market is an exchange of sorts where sellers offer shares of stock to buyers which represent investment into and partial ownership of a business. Despite the Wall Street connotation, the stock market isn’t an actual physical or electronic entity; instead, it’s a collection of financial transactions that occur. This network of transactions is called an exchange; companies list shares of their stock on these exchanges (for example: the New York Stock Exchange or the NASDAQ are commonly known U.S. exchange markets), and investors can purchase shares from these exchanges.

The simplest way to understand the stock market is to consider it as a way that businesses can raise money to invest in and grow their own business. In exchange for that capital, they offer a share of the ownership of their company to the investor; if the company is successful and grows as planned, the future value of that stock will be worth more than the investor paid for it, allowing them to make a profit. Within this simplified scenario, it’s easy to see the benefits for both company and investor.

The stock market, in reality, becomes much more complicated on the scale of the actual exchanges taking place, but to look at its effects on the overall economy, the specific details of stockbroker interactions aren’t really necessary.

Stock Market Importance

The stock market itself, made up of the number of institutions that manage it, is responsible for fair management of the number of trades and exchanges that make up the concept. This includes making sure the concept itself manifests: that there is a place (of sorts) where these transactions can occur in a regulated, secure environment, facilitated by a common set of standards that enable everyone to be able to access the same options. For example, in the U.S., the Securities and Exchange Commission (SEC) is the governing body responsible for overseeing the stock markets’ operations and regulations.

The intricacies of stock trading involve stockbrokers who match up buyers (offering to purchase X shares at Y price) with sellers (offering A shares for B price) when Y and B are the same value. The details can be found elsewhere; the point is that Y, the price a consumer will pay for a company’s stock, represents that vote of confidence in the company’s performance. If there is a huge mismatch between Y and B, the company offering shares needs to take another look at their strategies.

The Stock Market and the Economy

Both the stock market and the economy are terms for things that don’t actually physically exist. They operate on paper, electronically and within financial reports and analyses that are tracked worldwide. That being said, they have a distinct effect on each other.

In this sense, the economy represents the general financial state and well-being of a conglomerate, usually a state or a nation. When the U.S. economy is strong, for example, it can be generally assumed that businesses in the U.S. are doing well financially.

Good and Bad Performance

What defines good or bad performance? For the stock market, exchanges often create indices (for example: the S&P 500 or the Dow Jones) which represent an average of a subset of key performers; trying to represent the performance of every single public stock on the market is far too overwhelming of a calculation to be meaningful.

When a company’s share value rises, that means that the public perception of that company’s value has increased, due to positive financial performance; if an index rises, then the general average performance of stocks listed in that exchange can be expected to be positive.

Perceptions of Value

The changes in stock value, or in indices, are markers of the investors’ — and sometimes the public’s — perception of value. It’s a vote of confidence that the company is moving in the right direction, and that investors believe they will be able to see profits off of their investment.

Likewise, a decrease in stock value (or index) means that consumers are losing faith in the ability of companies to successfully make money. This representation of perception, or confidence, ties back into the fact that the stock market is not a physically measurable thing one can clearly define and calculate. It’s this factor that adds the unpredictability and the risk into the stock market — investors don’t necessarily follow any kinds of rules or mathematically predictable behavior.

In this way, the stock market can be representative of the economy. It’s important to note that they aren’t the same thing, but they’re tied together and tend to reflect one another. Changes in the stock market can lead to true changes in the economy’s performance, which leads to real economic situations that affect the business landscape.

Stock Markets and Lending

Another key portion of the U.S. financial landscape is the lending rate: the additional percentage one pays to borrow money from an institution over time. Lending rates are a critical portion of the economy, as they allow individuals and businesses to obtain capital for immediate investments, and allow lending institutions to make a profit over those loans. Interest rates are set by the Federal Open Market Committee (FOMC, or “The Fed”), and loaning institutions follow these trends.

Nature of Stock Exchange

When the stock market is rising, the overall perception is that businesses are doing well, and they will have money from their investors to further invest in loans. This makes lending rates rise, because with more demand, lending institutions can charge higher rates on the money they lend out, thus making more profit. This usually results in a balancing act, where interest rates rise until the market slows down, preventing the economy from over-inflating.

The Stock Market and Consumers

Since confidence is such a key portion of stock market performance, consumers (customers that buy goods, services and shares) are an incredibly important piece. The perceived performance of the stock market will affect consumer spending, which is then seen in a company’s bottom line. A good market builds consumer confidence, both in the consumer’s tendency to spend and in the consumer’s ability to find and hold a job where they will have the money to spend.

As long as the market is stable, consumers will continue to spend even when stock prices are decreasing. However, if companies stop hiring or offering raises due to falling stock prices, the consumer will ultimately be impacted and may spend less money. When consumers aren’t spending and aren’t investing, company performance will falter, and the stock market will show this as represented in stock prices.

As a general rule, a rising stock market will lead to more consumer spending because a higher stock market increases consumer wealth. Again, in general, higher consumer wealth relates to more consumer spending. There are always exceptions, but these are the general rules.

The Stock Market and Businesses

For individual businesses, stock market changes can impact finances in a number of ways: first, through consumer spending and second, through company investment into capital.

The increased consumer spending that’s seen during stock market growth translates to increased revenue for companies that sell goods and services in these growing markets. This environment leads to increased confidence in the stock market, and as seen above, consumer confidence is an indicator of additional positive performance. Likewise, when the stock market is falling, consumers are less confident and choose to save rather than spend; thus, company revenue will decrease, especially in the cases of luxury or non-essential goods and services, which are the first to be cut when stock prices drop.

Publicly Traded Companies

Stock market changes can also affect public companies directly, through the shares of stock they have on the market and additional shares they may consider selling. Businesses sell shares of stock to raise capital — immediate cash on hand — to invest back into the business; when the stock market is performing well and stock prices are high, companies often will choose to issue additional stock for sale, not only because higher prices create more capital, but also because consumers are ready to spend more on investments in these conditions.

During periods where stock market values are falling, companies usually don’t issue additional stock for purchase, since they won’t get as much return on shares. In such a scenario, individual businesses — especially small businesses — may turn to loans as a source of capital, rather than stock shares.

Stock Market and the Free Market

Overall, the stock market is meant to serve as a key component of the free-market economy. The purpose of the stock market is to offer a level playing field to all sorts of investors, and allow equal access to professional and common investors alike on a democratized platform. It’s a way for an individual to participate in the financial performance of larger corporations, obtain a small share of company ownership and potentially reap the benefits of a company’s performance through dividends. It’s also a mechanism through which businesses can grow and invest, which is meant to lead to a stronger economy for the country overall.

In reality, the stock market does provide these balances, but can be overrun to a point by investors who have more money available and, therefore, can accept the more potentially rewarding risks, due to deep pockets existing at the top of the U.S. economy. It’s up to individuals to decide how they want to invest their money.

References

About the Author

Danielle Smyth is a writer and content marketer from upstate New York. She has been writing on business-related topics for nearly 10 years. She owns her own content marketing agency, Wordsmyth Creative Content Marketing (www.wordsmythcontent.com) and she works with a number of small businesses to develop B2B content for their websites, social media accounts, and marketing materials. In addition to this content, she has written business-related articles for sites like Sweet Frivolity, Alliance Worldwide Investigative Group, Bloom Co and Spent.