The Stock Market and the Economy
Defined as the market in which equity shares of businesses are bought and sold, the stock market measures the aggregate value of publicly traded companies. It can be a valuable tool for gauging the health of the overall economy, though it occasionally misleads (old quip among economists: The stock market has correctly predicted 15 of the last three recessions).
For example, steep market declines preceded the Great Depression in the 1930s as well as the Great Recession of 2007-2009. However, some market crashes, most famously the Black Monday 1987, were not followed by recessions.
The Stock Market and Consumer Spending
Basically, consumers spend more during bull markets because they feel wealthier when they see their portfolios rise in value. During bear markets, they pull back on spending, fearing the loss of wealth and purchasing power as the value of their investments contracts.
A rising stock market signals investor confidence, as buying activity pushes up prices. When stocks rise, people invested in the equity markets gain wealth. Increased wealth often leads to increased spending, as consumers buy more goods and services when they're confident they are in a financial position to do so. When consumers buy more, businesses that sell those goods and services benefit in the form of increased revenues.
Stock market losses cause wealth erosion. A consumer who sees his portfolio drop in value is likely to spend less. This reduction in spending negatively affects businesses – particularly ones that sell non-necessity goods and services, such as luxury cars and entertainment, that customers can live without when money is tight.
The Stock Market and Business Operations
The stock market's movements also impact companies in a more direct way when they affect the value of a company's shares as a currency. Companies respond by raising more capital by issuing shares or by using its stock as leverage to buy companies or acquire competitors.
Businesses often grow by investing in themselves, and to do that, they need capital. One of the most effective ways to raise capital is to issue stock. Doing so when the stock market is up often generates a larger amount of capital. Potential investors exist in greater abundance, as more people put their money in stocks during bull markets. Prices are higher during a bull market, and so a company that is going public or issuing additional stock can sell each share for more money.
Stock can also be used as currency when a business wishes to expand. Consider a company in growth mode with a highly valued stock that wants to buy a struggling competitor. A portion of the agreed-upon purchase price may be rendered in stock, with the target firm considering it a good deal due to the health and strong outlook of the acquiring firm.