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Economy and Stock Market

2012 Feb 14


Stock Market and Economy

There is no doubt that economy and stock markets are related. When economy is weak it causes worse performance of the companies, and worse financial results affect valuation multiples of the companies, and then companies look not so attractive in the terms of such ratios as P/E ratio, PEG ratio or EV/EBITDA ratio


There is also affect of decreasing future prospects. It is popular to say, that stock market does not sell the fact, stock market sells rumors and forecasts. When economy is decreasing, naturally all investors are expecting that companies will fail to reach any growth or even worse, earnings are going to decrease.


And it would be unforgivable if not to mention fear factor which goes together with herd instinct. When economy is in recession everybody notice that stock market can not only rise but also lose some value. Then investors think of this as of some sort of surprise and start to sell their investments without any reasonable sense. When irrationality reaches its peak, undervalued stocks are sold at unreasonably low prices. Of course most of the investors regret for such investment decision later yet is too late to change anything. But the fall of stock market is much more limited if it is not accompanied by GDP contraction. 


Of course some business investors as commercial banks or capital investment groups are more resistible for psychological factors at investing.


Economic Indicator Analysis

There are many economical indicators that are important for the stock market. However, most of the investors are trying to pay more attention not to the most important indicators but to the earliest ones. Such indicator as changes in GDP may be the most important for the economy but it won’t say much to stock traders because this indicator is always lagging while stock market reacts to the healthiness of the economy much faster.


Those are the main economical indicators that show early information and are important for the stock market:


  • Inflation is very important indicator in two ways. Inflation is closely related to the mass of money circulation in the economy and if economy is booming then it is normal for inflation to increase. Any increase in core inflation may be a signal for economical growth. 
  • Sentiment indexes as consumers’ confidence or manufacturer confidence (the names of such indices vary over countries) are very early indicators and show the expectations of the market participants. If such indicators are decreasing, it is a bad signal for share investors.
  • Retail sales is a crucial indicator for investment growth that shows how people are tending to spend their money. Retail sales is a leading indicator and is important for many sectors.
  • Building permits are mostly important for construction sector, but the volatility and the scale of construction sector has an impact to overall economy. Rise in building permits shows that there is possible to increase real estate investments and that would mean more work for construction companies which is very healthy for the economy.
  • Industrial production and industry orders are very sensitive and early indicators. Industry is most volatile sector in the economy and has crucial impact to the economical cycles. 



Stock Market Impact on Economy

Another early indicator is a stock market index. The fact that stock market is affected by the economy is unquestionably correct, but another true is that stock market also affects the economy. It can be as vicious circle if situation gets out of control because those are affecting each other. 


Stock market impact on economy is especially strong in markets where investment is very popular. If many people are investing in stocks, they get influenced by stock market movements. For example, till people are investing successfully they are enjoying by stock value increase. After some period they start to feel rich and they take out some cash from investment portfolio and spend those money. Investment information not always is clear and leads to the best investment solutions. That money circulates in the economy and pushes it up even more. But when stocks start to decrease, investors cannot take out profits from their investments because there are no profits anymore. In this way stock market has impact to overall economy. 


Read next article: Right time to stop investing.


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