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Knowledge Center » Economics » STOCK MARKET AND THE ECONOMY

Stock Market and the Economy
There is obviously a link between real economic activity and stock prices. But this link is shaky and flimsy. The relationship is not as simple as one going up along with the other and vice-versa. The complication lies in the fact that the elements affecting stock prices are too complex, disintegrated and contradictory for a simple “up and down” correlation to be applied.Without a doubt, the business cycle plays a role in this whole scenario. If the chart of business cycle fluctuations is superimposed on a stock market index, it can be noticed that the stock market generally and roughly follows. But the problem lies in the usage of the words ‘generally’ and ‘roughly’. As we begin to examine the other reasons with the power to affect the stock market other than the economic scenario, the complexities arise.

●    Interest Rates
If the interest rates are likely to fall, stocks will be purchased and their prices will rise. But there are also order quantities for our goods which push up stock prices when they rise and vice versa. But again, foreign demand depends partly on exchange rate which depends partly on the interest rate.

●    Investor Psychology
People tend to plunge into overheated markets and panic and leave at exactly the best time to buy. The past shows how markets overshoot and push prices up to levels not justified by the real economy. And on the contrary, we have people selling out more than the economic situation justifies; simply because sentiment is pessimistic.

●    Speculation
A basic reason for buying stocks is that people contemplate and expect other people paying more for their stock in the future. This is the essence of speculation which can drive buyers and sellers.

●    Political Factors and Sundry Disasters
An election, a terrorists attack, an epidemic and other shocks in the real world, long term or short term, can help you make or lose money. These on-economic factors are reflected in the stock market as well.While some factors drive the stock prices up, other drive them down and sometimes the same variable can have opposing effects when measured against other variables. So we have a simultaneous and many-sided action of forces working in all directions with varied intensities.Stock prices are driven by a very messy combination of economic, psychological and political reasons making it impossible to predict which “fundamentals” and “non-fundamentals” will prevail. However, it is often possible to make out which of them will dominate over time, especially in a short run. Eve though it is not all a game of chance, thinking that the business cycle and the stock exchange cycle are the same, is a bad option.The trick is not to try and figure out all aspects, but to decide what factors are likely to matter over the given period of the investment and time. If the economy is performing well, the stock market is likely to do the same but there is no consistent pattern that proves out to be the same over all market cycles.