How the Stock Market Affects the U.S. Economy

“The stock market is not the economy” is a phrase that gets used quite often. Many pundits argue that the fluctuations of the major indexes tasked with tracking the performance of the country’s biggest companies have little impact on the average American, as the majority of shares trade hands among the super-wealthy.

While it’s true that the richest Americans own most of the stocks, it’s wrong to assume that nobody else is affected by how they are valued. Record numbers of American households are investing their savings in equities to secure their financial futures. And let’s not forget that the constituents of the stock market are the companies that produce goods and services, provide the population with jobs, and basically power the economy.

Read on to discover some of the key ways that the stock market affects the U.S. economy.

Key Takeaways

  • The majority of Americans have exposure to the stock market through their retirement plans, meaning that its performance can affect how much the population has to live on in retirement.
  • When share prices rise, people are generally willing to spend more, and vice versa.
  • Keeping shareholders happy can force companies to adopt measures that affect the general public and the economy.
  • The higher the shares are valued by the market, the more companies stand to make from a rights offering.
  • Stock market crashes have led to economic recessions.

Retirement Money

To secure enough money to live on in retirement, it’s generally necessary to park a portion of earnings from each paycheck into the stock market. Retirement plans invest predominantly in company shares, as they offer a decent chance of growing in value, beating inflation, and turning whatever we can afford to put aside for our older selves into something more.

Through retirement plans, the lion’s share of Americans have exposure to the stock market. If valuations go up for a prolonged period, people could have more to live on when their time in the workforce comes to an end. Conversely, a lengthy bear market may result in smaller retirement funds, bigger welfare checks, and less money swirling around the economy.

Corporate Fundraising

Public companies sometimes issue new shares to raise extra funds. With a rights offering, shareholders are invited to purchase additional slices of ownership in the company, usually at a slight discount to the current price at which the shares are trading. It is a relatively low-cost way to generate money but is generally less favorable when share prices are depressed.

Essentially, the higher the shares are valued by the market, the more companies stand to make from a rights offering. This extra capital can have a profound impact on lots of people, as business investment triggers higher economic output and creates more jobs.

Short-termism

Companies that trade publicly on the stock market must keep their shareholders happy or risk plummeting in value. The problem is that what shareholders want doesn’t always align with the long-term interests of the company.

The stock market has a tendency to encourage short-termism. Not all investors are patient, with many of them demanding bigger dividends and profits to stay onboard. That can result in less funds being available to improve and expand the business and management recklessly identifying quick ways to cut costs, such as by laying off staff or saving money on production costs to the detriment of consumers.

The Wealth Effect

Shareholders are happier when the shares that they hold rise in value. During these moments, they are more likely to feel secure about their finances and be willing to spend money.

The relationship between stock market performance and consumer spending, which accounts for approximately 70% of the U.S. economy, is a hotly debated topic. Lots of economists claim that share price movements mainly affect the super-wealthy, who happen to have plenty of money and spending patterns that aren’t influenced by how much their investments fluctuate in value each day. However, many regular Americans also own shares and depend on the returns that they generate to achieve their financial goals—reportedly more than ever before. When their portfolios take a hit, there’s a decent chance that they’ll spend fewer dollars propping up the economy.

35.5%

The share of household wealth that comes from directly or indirectly held stocks, according to the Federal Reserve System.

Warning of Imminent Recessions

The stock market is forward-looking. Prices are based on what investors expect companies to do in the future, and that inevitably means predicting to an extent the state of the economy, as economic conditions often influence revenues and profitability.

Two of the worst economic shocks on record, the Great Depression of the 1930s and the Great Recession of the late 2000s, were preceded by a major sell-off of stocks.

Nobel laureate Paul Samuelson once famously said that the stock market had predicted nine of the past five recessions. That’s not a perfect track record but still perhaps enough to make the general public worry anytime newspapers mention that companies are shedding value, with consumers subsequently becoming more cautious in how they handle their finances.

The stock market functions as a kind of economic barometer, reflecting opinions on which direction big wealthy investors think the economy is heading.

Does the stock market correlate to the economy?

There definitely is a relationship between the two. Official updates on the state of the economy, such as inflation and employment figures, have a big impact on share prices. And the movement of the stock market itself can affect how much people spend and how much companies invest.

Why is the stock market important to the United States?

The stock market enables companies to raise money and the public to profit from their growth prospects. When all goes to plan, this is a win-win for the economy.

What is the biggest component of gross domestic product (GDP)?

Gross domestic product (GDP) tells us the total monetary value of all the finished goods and services produced within a country’s borders in a given time period. It consists of four key components—personal consumption expenditures, business investment, government spending, and net exports of goods and services—with consumer spending being by far the most influential.

The Bottom Line

As we’ve been repeatedly told for years, the stock market and the economy aren’t the same thing. This doesn’t mean that the former has no impact on the latter, though. In many cases, the fates of both are closely intertwined, with the economy influencing the stock market, and vice versa.

When stock markets rise or fall sharply, it can alter how confident people feel about their finances and how much they might have to spend in the future. It can also have a bearing on how companies allocate their funds and the amount of capital that they are able to raise to expand their operations. Taking the above into consideration, it would be foolish to assume that the average American is in no way affected by the buying and selling of shares.

Article Sources
Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy.
  1. CNBC. “The Wealthiest 10% of Americans Own a Record 89% of All U.S. Stocks.”

  2. Twitter. “@RBReich, 12:22 p.m., Dec. 16, 2020.”

  3. Federal Reserve System. “Changes in U.S. Family Finances from 2016 to 2019: Evidence from the Survey of Consumer Finances,” Page 18.

  4. Federal Reserve System. “Changes in U.S. Family Finances from 2016 to 2019: Evidence from the Survey of Consumer Finances,” Page 3.

  5. Federal Reserve Economic Data, Federal Reserve Bank of St. Louis. “Shares of Gross Domestic Product: Personal Consumption Expenditures.”

  6. Federal Reserve Economic Data, Federal Reserve Bank of St. Louis. “Households and Nonprofit Organizations; Directly and Indirectly Held Corporate Equities as a Percentage of Financial Assets; Assets, Level.”

  7. U.S. Federal Deposit Insurance Corp. “Historical Timeline.”

  8. International Monetary Fund. “World Economic Outlook: Slowing Growth, Rising Risks,” click on “Download Full Text,” go to Page 51 (Page 70 of PDF).

  9. The FRED Blog, Federal Reserve Economic Data, Federal Reserve Bank of St. Louis. “Graphing GDP Components with Our New Release View.”

Take the Next Step to Invest
×
The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace.
Service
Name
Description