Market Theory
IT’S NOT THE ECONOMY
“Upon closer inspection ... this link is murky.”
So why do we care about the stock market?
What we talk about when we talk about stocks.
If you read business news, you hear it constantly.
“The S&P 500 has been on a tear since Nov. 1, rallying some 20% on the back of strong earnings, economic optimism, and... ” (WSJ)
“The U.S. stock market is off to a soaring start in 2024, as optimism over the economy and interest rate cuts has combined with... ” (Reuters)
“Optimism about the U.S. economy sends stocks to a new record... ” (NPR)
A lot of what gets written about the stock market assumes a clear connection between rising price in the equity market and an improving economy.
I’ve been covering financial markets for 15 years at The New York Times, The Wall Street Journal, Axios, and a few other spots. I’ve probably included the same implicit logic in stories hundreds of times.
But here’s the thing. It’s really not true.
For a century now — since the Wall Street boom of the 1920s — Americans have conflated the market with the economy, in a mass socio-cultural confusion of correlation and causation.
It started as a freak of history. In the 1920s, the US economy surged as America emerged from World War I as the world’s top economic power.
At the same time, the stock market saw a massive boom unlike any before. Using another new technology, modern advertising techniques, Wall Street managed to persuade Americans — many of whom were enjoying the novel experience of having a little extra cash in their pockets — to buy stocks for the first time. It worked. The 1920s bull market was born.
Then came the Crash of ’29, followed by the Great Depression, a one-two punch that strengthened the linkage between the fate of the economy and the path of the market in the American psyche.
The thing is, economists have looked for ironclad proof that the stock market has some sort of relationship to the economy for years. They’ve largely come up short.
One of the most widely cited surveys papers, summing up all the economic literature on the ability of financial market movements to predict economic growth, said that while economists have often noted some sort of link between stocks and growth, “upon closer inspection, however, this link is murky.”
“Stock returns generally do not have substantial… predictive content for future output,” said the paper, published in the American Economic Association’s Journal of Economic Literature in 2003.
A separate 2010 paper by a bunch of well-known economists looking at the predictive power of a range of financial indicators found that the stock market “outperformed” other indicators in prediction, but none of their indicators were especially great.
OK, so maybe markets don’t predict growth. That’s somewhat inconvenient, seeing as they’re widely credited with being “forward-looking.” But maybe they simply reflect economic growth in real time?
Nope, not according to a 2005 paper in the Journal of Applied Corporate Finance, which actually found a negative relationship between actual economic growth and investment returns, in a long-term study of 19 countries. That means they found stocks typically rose when the economy worsened, and vice versa.
So where does this leave us? If the stock market doesn’t tell us about the economy, does the stock market matter? Are we giving stocks too much attention? Does the market really matter?
That’s sort of like asking if sports matter. They do. Not to everybody. Not all the time.
But if you find them fascinating; if you’re interested in strategy and competition; if you have a particular rooting interest; if you’re interested in human behavior, or in mass psychology, or new trends, or great stories, they matter.
And let’s just be honest. Sports also matter to a lot of people who gamble on them. They can cost you — or make you — money. The US does have a record high share of households, 58%, who own stocks. (On the other hand, the vast majority of those holdings are pretty small. More than 90% of the stock owned by households belongs to the richest 10% of American families.)
So yes, the markets matter. Not because they’re some magic barometer that can tell the economic future. But because they’re an incredibly rich source of information and great stories about the world right now.
