Does the Stock Market Relate to the Economy? Here's How

People often parrot the phrase "the stock market is not the economy," and that's largely true. Stock market and economic performance don't always match up.

This was a hard truth to swallow during the throes of the pandemic. In much of the world, unemployment rates increased, yet the stock markets thrived, causing many to wonder how the market could be so healthy while the economy suffered. The reality is they're separate things. 

But while they're not equal, that doesn't mean they're mutually exclusive. A nation's economy and its stock market exchanges are strongly linked and can impact one another, whether in the US, the UAE, or elsewhere. 

Defining the terms: stock market and economy

First off, let's define what these two terms actually reference: 

• Stock market: The stock market is a collection of exchanges where individual and institutional investors come to buy and sell shares of stocks and securities from publicly held companies.

• Economy: Generally, the economy refers to the series of activities for the production, consumption, and distribution of goods and services. 

Why the stock market is not the economy

Here are a few reasons why the stock market and the economy aren't one and the same. 

1. Not everyone who is part of the economy participates in the stock market. Only about 55% of the US population owns shares in the US stock market. In the UAE, a large percentage of its stock exchanges are accessible to foreign investors, so its markets don't necessarily reflect the health of the local economy. 

2. The stock market indicates the strength of consumer confidence in the future, since people buy shares of companies they expect to grow. However, the economy is demonstrated in factors like unemployment rates and spending. 

3. Large corporations tend to make up a majority of the stock market, while small businesses are major economic drivers. 

Does the stock market affect the economy?

Here's why the stock market and the economy actually aren't disconnected.

The stock market allows individuals to invest in and profit from economic growth. Thanks to public stock exchanges, anyone can own a piece of a company. The more successful small investors become, the more money they can inject back into their local economies and Gross Domestic Product (GDP). 

Another way the market impacts the economy is that companies going public are able to raise necessary capital (aka money) that helps them expand. Companies need funding in order to grow and thrive, and offering shares on the stock market allows investors to have a role in that process.

A negative correlation between the stock market and economy occurs when the market crashes or drops significantly. Lower stock prices can devastate retirement accounts and pensions (retirees don't always have the time to rebalance a portfolio after a major crash before withdrawing funds), which in turn impacts spending within the economy. 

As a beginner investor, remember this: While the economy and the markets aren't always equally healthy, they do affect each other in vital ways.