GDP and Its Relationship with the Stock Market
The performance of the United States stock market and GDP (Gross Domestic Product) are two key financial indicators that can be used to aid decision making. While investors are often reminded that the stock market isn’t the economy, it does have a close relationship with economic performance. GDP is a direct measure of the economy. Performance across both indicators isn’t always aligned.
How Can the Stock Market Affect GDP?
The stock market has a small direct impact on GDP, but it is still a factor.
When stock market confidence is high, it can have a trickle-down effect, increasing consumer confidence and leading to an increase in consumer spending. When the stock market hits new highs, the news is featured in the major headlines. Even people that don’t follow the stock market can have their spending patterns swayed by the news.
The stock market also creates value for the economy in terms of investor returns. Returns through stock sales, trades, and dividends can inject more spending money into the economy. At an institutional level, big stock gains can lead to more capital for companies that then spend on products, services, and expansion outside of the market.
How Does GDP Affect the Stock Market?
Looking at it from the other side, current GDP can have a real and measurable impact on the stock market, although it isn’t always consistent.
Strong GDP performance indicates a strong economy, which can embolden investors. More activity in the markets can lead to share price gains, which then raises the major indexes. If GDP falls, investors have less confidence in the economy which can slow their trading activity.
However, contrarianism is a real phenomenon in the market. Some picks are made in complete opposition to economic signals. Investors can also buy during economic dips with the hope of finding discounted stocks that will recover when the economy picks back up.
Investor sentiment is complex and sometimes investors ignore GDP altogether. An example can be taken from earlier in the year.
Take a look at the following chart published by the U.S. Bureau of Economic Analysis [1].
It shows that real GDP fell -5% sequentially in the first quarter and then more than -25% sequentially in the second quarter of this year. Those quarters ran from January to July and represented one of the worst economic recessions in American history.
The next chart, which shows the growth of the Dow Jones Industrial Average stock market index, reveals that while there was some correlation of the dip when compared to GDP, it quickly recovered, despite GDP tanking throughout the second quarter [2].
The Cares Act of 2020 was passed on March 27. It was a $2 trillion economic relief package that included direct support for businesses and workers. It included $1,200 stimulus checks for individuals. This package, despite poor GDP performance, gave investors confidence for an economic recovery.
Should GDP Factor Into Investment Decisions?
The stock market is hitting record highs today. This is happening despite the massive declines in GDP due to the Coronavirus. This can leads to the assumption that the current market prices are more a reflection of consumer confidence then actual market growth.
The stock market has outperformed all expectations this year despite America facing an economic downturn and a deadly pandemic in tandem. How long will this trend continue? It can be assumed that this is closely correlated with the governments ability to inject capital into the markets and provide stimulus to the economy. Major volatility should be expected.
GDP can influence stock markets and the reverse is also true, but the two don’t always have a direct and proportionate relationship.
Resources
- Bureau of Economic Analysis Gross Domestic Product Chart – https://www.bea.gov/news/2020/gross-domestic-product-third-quarter-2020-advance-estimate
- Trading View Chart Tool – https://www.tradingview.com/