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The Relation Between the GDP and Stock Market that We Need to Know

24 Feb 2022 0 COMMENT

What is the first thing that comes to your mind when you hear the term economy? Many different things and complex terms would come to your mind, but if we take a trip down our memory lane to the very basic classes of economics in our high school, the term that always cropped out was Gross Domestic Product (GDP). What is it? How to calculate it and how does it impact your life? Ahh..so many questions, don’t fret, in this article you will get all your questions answered!

The GDP is basically the total value of the goods and services produced in a country. The “total value” here means the value of goods and services that are produced minus the value of goods and services that are needed to produce them.

Simple enough?

You might wonder why GDP is important to study while we are invested in the stock market. Whenever we say that an economy is growing at 'x' percent, it means the GDP of that country is growing at that rate.

As we know, the stock market mainly depends on the performance of the listed companies. However, a country's domestic and global economic situation plays a vital role in the demand for the goods and services of a company, thus affecting its profitability and growth. Today, we will discuss the correlation between GDP and the Stock market. Whether or not GDP is a reliable gauge of the stock market has been a question that has troubled economists for ages now.

 Before we start to get deep into the topic we must know that GDP is primarily driven by spending and investment.

The below picture is an algebraic representation of GDP. Don't worry, nothing to be scared of in this formula, you will get a hang of it as we move forward.

GDP = C + I + G + (X -  M)

Or GDP = Consumption + Investment + Government Spending + (Exports – Imports)

The first component of GDP is consumer spending…

When the consumption is high, the people are buying things which indicates that there is money in hand which helps in growing the GDP.

When do businesses spend? When they have cash in hand right? Business spending includes the purchases made by the company which is a positive indicator for both GDP and stock market.

When the exports are higher than imports, the country is less dependent on foreign goods and therefore the domestic companies are flourishing, which yields high earnings for the domestic companies.

Government will spend only when they have surplus surplus (no, that is not a typing error) money and when they do they boost the economy which gives the beneficiaries a cushion to expand their operations which results in higher profits and thereby may be higher stock prices.

But how to gauge the inference of one from the other? To understand this let’s introduce the concept of the leading and the lagging Indicators? It can be well understood by the example of the windshield and rear view indicator. You might have got a brief idea as to why are we comparing these indicators to car’s parts. So simply put, when you are looking out of the windshield, you are watching what lies ahead of you, which is termed as leading indicator. On the other hand, when you see through the rear-view mirror you are looking at the road you have already covered, therefore naming it to be as a lagging indicator.

Lagging indicator is a measure which acts as a performance indicator for the things that have occurred in the past, which can be sales, profits, amongst many more, and one of the majorly used lagging indicator is the GDP. On the other side of the coin we have the Leading indicator which helps and predict future events in the economy. Investors try to time the market by keeping a close eye on the leading indicators, one of which is the Stock market. If there is sharp increase in the stock market, then you expect the economy to strengthen in the future.

The chicken and egg dilemma comes into our mind when we try to understand the impact of the bull market on the economy. Whether GDP numbers will rise first or the stock market will rise first. As the stock market is a leading indicator, you will see the impact in the stock market first. On the other hand, GDP being a laggard indicator, will follow the trend. A bull market is when the markets are rising. So when does a stock rise? One reason behind it can be that there is super optimism around the stock. To look at a larger picture, when there is optimism enveloping the economic outlook.

Conversely, Bear markets are a scenario wherein the investors are pessimistic and expect a fall in stock prices. This pessimism affects the company to expand further and economy start showing the sign of contraction and leads to a falling GDP.

After reading this article, you might have got a clear viewpoint on the synergy of the GDP and the stock market. With that being said, both the Stock market and GDP will move in the same direction; the only difference is one is behind the other.

Key takeaways:

  • GDP and Stock market performance have strong synergies.
  • A lagging indicator is a measure that acts as a performance indicator for the things that have occurred in the past and GDP is a lagging indicator.
  • The leading indicator helps in predicting future events in the economy and the Stock market is considered as a leading indicator.

Disclaimer:

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