The stock market affects gross domestic product (GDP) primarily by influencing financial conditions and consumer confidence. When stocks are in a bull market, there tends to be a great deal of optimism surrounding the economy and the prospects of various stocks. High valuations allow companies to borrow more money at cheaper rates, allowing them to expand operations, invest in new projects, and hire more workers. All of these activities boost GDP.
In this environment, consumers are more likely to spend money and make major purchases, such as houses or automobiles. With stock prices in bull mode, they have more wealth and optimism about future prospects. This confidence spills over into increased spending, which leads to increased sales and earnings for corporations, further boosting GDP.
The Negative Effect of Low Stock Prices on GDP
When stock prices are low, it negatively affects GDP through the same channels. Companies are forced to cut costs and workers. Businesses find it difficult to find new sources of financing, and existing debt becomes more onerous. Due to these factors and the pessimistic climate, investing in new projects is unlikely. These have a negative effect on GDP.
Consumer spending drops when stock prices decrease. This is due to increased rates of unemployment and greater unease about the future. Stockholders lose wealth with stocks in a bear market, denting consumer confidence. This also negatively affects GDP.
The stock market's effect on GDP is less discussed than the effect of GDP on the stock market because it isn't as clear. When GDP rises above consensus or expectations of GDP rise, corporate earnings increase, which makes it bullish for stocks. The inverse happens when GDP falls lower than consensus or expectations of GDP decline. (For related reading, see: Economic Indicators That Affect the U.S. Stock Market.)