Stock Market is a Bad Economic Indicator

Feb 28, 2009 | By: Mr_Blue | Tags: economy, stock market, economic indicators

We have been programmed, or at the least unintentionally misled, into believing that the stock market is a good measure of how the economy is doing.  We hear it in passing in the news everyday: “The Stock Market closed down today on news that” something happened and because of that piece of information we think the economy is not doing well.  This is not a good way to look at our economy particularly with our current economic crisis.

What do they mean by the “stock market”?  The news sound bites about the stock market usually refer to one of three indices:

  1. Dow Jones Industrial Average - measures the stock performance of 30 “blue chip” U.S. companies.
  2. S&P 500 - measures the stock performance (value weighted) of 500 large capitalization common stocks actively traded in the U.S.
  3. Nasdaq Composite Index - measures all NASDAQ U.S. and international based common stock listed on the NASDAQ Stock Market.

These indices are excellent measures of how the equity or stock market is doing but that is it.  Contrary to what I was taught in business school the stock market is not rational.  The stock market is nothing more than a place for people or entities to exchange something of value.  The stock market is prone to whims and herd mentality.  Stock values or prices are often not even based on balance sheet fundamentals.  For instance, remember not to long ago - internet craze/bubble where some internet company stocks were reaching over $100 per share based on nothing more than idea that the internet will solve all of our problems.  These internet companies had negative cash flows and were projecting no income for years but the stock market valued them at $150 per share.

Our current economic crisis is another reason why we cannot rely on the stock market as an economic indicator.  First, according to the National Bureau of Economic Research our current recession official began in December 2007.  But, the Dow Jones Industrial Average was hovering above 13,000 not far from its record 14,000 point mark.  Today, the Dow Jones Industrial Average is at 7,000.  Second, our current economic crisis began in the credit markets and truly is a crisis of credit (debt instruments) versus equity (stocks).  If anything, we should be paying attention to credit market indicators to determine if our economy is improving.  If this is too complicated then there are the more published indicators such gross national product (GNP) reports and unemployment rate reports (although often understates true unemployment).

Good luck.

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