Investors may freak out when the economy declines, but stocks and the economy aren’t closely related.
Many investors believe the economy closely influences the stock market, arguing when the economy suffers so will stocks.
This is flawed, as there have been times when the economy and stocks go in different directions. Stocks and the economy go in the same direction almost as often as opposite, therefore relating the two closely is not accurate.
There is also the difference of stocks being priced at a future value; thus, they are speculative in nature.
There are two main theories on how stock is valued.
First, the firm-foundation theory believes there is intrinsic value, based on the current dividends and estimated potential in the future, and the idea stock will always regress to an intrinsic value.
Castle in the air theory believes the price of stock is solely based on what people will pay for it and is entirely psychological in nature.
Both theories, often used by investors to play stocks, are based on the future value and not the present value. The economy is the measure of current economic activity and is not speculative.
You could argue most of the time people conflate the stock market and the economy, it is a direct effect of “bubbles.”
Bubbles are stocks or assets with an inflated price far above the future expectations of growth. When the bubble pops, prices plummet, and the economy can suffer.
The most well-known bubble occurred in the 1920’s – this bubble pop led to the great depression.
There are now regulations in place to mitigate the effects another stock bubble can have on the economy, and most modern bubbles are tied to a specific sector of the economy.
There have been other bubbles throughout history not related to the stock market.
The oldest bubble is known as tulip mania, occurring in the 1630’s. The tulip bubble saw the price of tulip bulbs rise so high, the price of a bulb was six times the average person’s annual salary.
Considering bubbles are not tied directly to stocks, but can exist in other forms of assets, it is more accurate to say bubbles, not stocks, can affect the economy.
Although the economy and stocks can seem closely related at times, in truth they mostly act independent of one another.
