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Recent experience indicates a disconnect between financial markets and the economy.  

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Recent experience indicates a disconnect between financial markets and the economy.  

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The two have been intertwined in the American psyche since the 1929 stock crash and the onset of the Great Depression. But stocks are not a reliable gauge of overall economic health.

A double-exposure image showing a stock plunge in early March and a rush to buy supplies at a Costco in East Harlem. Credit... Mark Abramson for The New York Times

The stock market looks increasingly divorced from economic reality.

The United States is on the brink of the worst economic collapse since the Hoover administration. Corporate profits have crumpled. More than a million Americans have contracted the coronavirus, and hundreds are dying each day. There is no turnaround in sight.

Yet stocks keep climbing. Even as 20.5 million people lost their jobs in April, the S&P 500 stock index logged its best month in 33 years. After a few weeks of wild swings, the market is down a mere 9.3 percent this year and 13.5 percent from its peak - what most investors would consider a correction. On Friday, after the government released the staggering unemployment figures, the S&P 500 closed up 1.7 percent.

Conventional wisdom would explain the market's comparatively modest losses this way: Since markets tend to be forward-looking, investors have already accounted for what's expected to be a cataclysmic drop in second-quarter activity and are forecasting a relatively rapid economic recovery afterward. The Federal Reserve's actions have also bolstered investors' confidence that the bottom won't fall out of the market.

But the pandemic has also highlighted a deeper trend. For decades, the market has been growing increasingly detached from the mainstream of American life, mirroring broad changes in the economy.

"Wall Street has very little to do with Main Street," said Joachim Klement, a market analyst at Liberum Capital in London. "And less and less so."

Still, the market retains its grip on the collective imagination. From politicians and corporate executives to mom-and-pop investors, Americans have long relied on the stock market as a proxy for the U.S. economy - for reasons that are partly historical. Its crests suggested bright days ahead, while its troughs suggested a darkening outlook. The current economic fallout, however, could snap any illusions that the logic of the market is derived, in any consistent way, from real-world events.

Part of the reason is the makeup of the stock market, and the fact that the giant companies that make up the S&P 500 operate under very different circumstances than the nation's small businesses, workers and cities and states. They are highly profitable, hold significant sums of cash and have regular access to public bond markets. They're far more global than the typical American family firm. (Roughly 40 percent of the revenues of S&P 500 companies come from abroad.)

In 2015, about 600,000 U.S. companies counted at least 20 employees, and only 3,600 of those - or less than 1 percent - were publicly listed, said René Stulz, a professor of finance at Ohio State University, who has studied the changing composition of publicly traded markets.

Because the financial strength of big companies makes them more likely to survive the downturn, their share prices tend to underplay the impact of a widespread economic collapse. In fact, market indexes like the S&P 500 are weighted to reflect the performance of the largest and most profitable companies. In recent weeks, the stocks of such companies have not only veered in the opposite direction of the outlook for the U.S. economy, but from the rest of the stock market itself.

The five largest listed companies - Microsoft, Apple, Amazon, Alphabet and Facebook - have continued to climb this year, as investors bet these behemoths will emerge in an even more dominant position after the crisis. Through the end of April, these companies were up roughly 10 percent this year, while the 495 other companies in the S&P were down 13 percent, according to Goldman Sachs analysts. These highly valued firms - Microsoft, Amazon and Apple are each worth more than $1 trillion - now account for one-fifth of the market value of the index, the highest level in 30 years.

"It's very easy to get confused by looking at the S&P doing well and that being driven by a relatively small subset of firms which aren't really affected by this virus and actually gain from it," said Mr. Stulz.

Nor does the mood of the market necessarily reflect the sentiment of a broad swathe of Americans. While U.S. stock markets are more democratic than most, with more than half of American households owning shares or investment funds like mutual funds, the overwhelming majority of stock accounts are relatively modest. Rather, stock ownership is heavily skewed to the richest segments of the population, who are least likely to feel the pain of an economic downturn.

"Stock ownership among the middle class is pretty minimal," said Ed Wolff, an economist at New York University who studies the net worth of American families. He added: "The fluctuations in the stock market don't have much effect on the net worth of middle-class families."

In fact, a relatively small number of wealthy families own the vast majority of the shares controlled by U.S. households.

The most recent data from the Federal Reserve shows that the wealthiest top 10 percent of American households own about 84 percent of the value of all household stock ownership, according to an analysis by Mr. Wolff. The top 1 percent controlled 40 percent of household stock holdings.

Economists who have studied the performance of stock markets over time say there's relatively little evidence that economic growth matters to the outcome of the market at all.

"The linkage is actually pretty weak," said Jay Ritter, a finance professor at the University of Florida who has studied the long-run relationship between economic growth and market returns in world markets. "In the longer run, the relationship is, empirically, it's not there."

None of this is a secret. So why do millions of Americans continue to think the market really is a barometer on the economy? That's more a question of history and culture than economics.

Historians say the stock market's link in the American psyche to the economic health of the country goes back, at least, to the 1929 crash.

"You can think of the Great Crash as almost traumatizing Americans," said Janice Traflet, a financial historian at Bucknell University's Freeman College of Management.

With little quality economic information, many Americans saw the 1929 market collapse - the S&P fell an astounding 86 percent before bottoming in 1932 - as the event that caused the Great Depression. The close connection between the health of the economy and the health of the markets, in the minds of many Americans, had been forged.

"Whether or not they were right or wrong that's the way many Americans interpreted it. And sometimes perceptions become the reality," said Ms. Traflet.

The crash put mainstream America off the stock market for decades. But by the 1950s, a marketing push from major Wall Street institutions began to coax newly affluent Americans to invest as postwar prosperity grew. The New York Stock Exchange pushed a campaign urging people to "own your share of American business."

During the 1950s and 1960s, it was easier to link the health of the largest American companies with the broader health of the country, partly because their enormous payrolls helped fuel the expansion of the middle class.

According to a Brookings Institution report, for example, the two most highly valued companies in the country in 1962 - AT&T and General Motors - employed nearly 1.2 million people combined. Last year, the two largest companies in the S&P 500 - Microsoft and Apple - employed 280,000.

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Repeat After Me: The Markets Are Not the Economy (Published 2020)

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The two have been intertwined in the American psyche since the 1929 stock crash and the onset of the Great Depression. But stocks are not a reliable gauge of overall economic health. The stock market looks increasingly divorced from economic reality. The United States is on the brink of the worst economic collapse since the Hoover administration.

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Conventional wisdom suggests that financial markets help in fair allocation of resources  and makes an economy more productive.     

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Conventional wisdom suggests that financial markets help in fair allocation of resources  and makes an economy more productive.     

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Great question. The simple response is that well-developed, smoothly operating financial markets play an important role in contributing to the health and efficiency of an economy. There is a strong positive relationship between financial market development and economic growth. For example, in Chapter 1 of their 2001 book, Financial Structure and Economic Growth, editors Demirgüç-Kunt and Levine concluded:

In particular, researchers have provided additional findings on the finance-growth nexus and have offered a much bolder appraisal of the causal relationship; firm-level, industry-level, and cross-country studies all suggest that the level of financial development exerts a large, positive impact on economic growth.

Financial markets help to efficiently direct the flow of savings and investment in the economy in ways that facilitate the accumulation of capital and the production of goods and services. The combination of well-developed financial markets and institutions, as well as a diverse array of financial products and instruments, suits the needs of borrowers and lenders and therefore the overall economy.

What are financial markets and institutions?

Financial markets (such as those that trade stocks or bonds), instruments (from bank CDs to futures and derivatives), and institutions (from banks to insurance companies to mutual funds and pension funds) provide opportunities for investors to specialize in particular markets or services, diversify risks, or both. As noted by Demirgüç-Kunt and Levine, together financial markets and financial institutions contribute to economic growth; the relative mix of the two does not appear to be an important factor in growth.

Large financial markets with lots of trading activity provide more liquidity for market participants than thinner markets with few available securities and participants and thus limited trading opportunities. The U.S. financial system is generally considered to be the most well developed in the world. Daily transactions in the financial markets-both the money (short term, a year or less) and capital (over a year) markets-are huge. Many financial assets are liquid; some may have secondary markets to facilitate the transfer of existing financial assets at a low cost. Table I provides a list of several well-known U.S. financial markets, ranked by outstanding assets or liabilities as of 2004.

The U.S. also has a well-developed financial services industry. It includes such familiar types of financial institutions as banks, pension funds, mutual funds, and insurance companies. Table II provides a list of several categories of U.S. financial institutions, ranked by outstanding assets as of 2004.

TABLE I

Selected U.S. Financial Markets, Outstanding Assets or Liabilities as of 1999 and 2004.
(Federal Reserve System, Flow of Funds, June 9, 2005)

Federal Gov't Total Treasury Securities Liability
(ex. Savings bonds)

TABLE II

Selected U.S. Financial Institutions and Funds, Assets Outstanding as of 1999 and 2004.
(Federal Reserve System, Flow of Funds, June 9, 2005)

State and Local Government Employee Retirement Funds

For comparison purposes: U.S. GDP in current dollars in 2004 was $11,735 billion.

Why are financial markets and institutions important?

Financial markets play a critical role in the accumulation of capital and the production of goods and services. The price of credit and returns on investment provide signals to producers and consumers-financial market participants. Those signals help direct funds (from savers, mainly households and businesses) to the consumers, businesses, governments, and investors that would like to borrow money by connecting those who value the funds most highly (i.e., are willing to pay a higher price, or interest rate), to willing lenders. In a similar way, the existence of robust financial markets and institutions also facilitates the international flow of funds between countries.

In addition, efficient financial markets and institutions tend to lower search and transactions costs in the economy. By providing a large array of financial products, with varying risk and pricing structures as well as maturity, a well-developed financial system offers products to participants that provide borrowers and lenders with a close match for their needs. Individuals, businesses, and governments in need of funds can easily discover which financial institutions or which financial markets may provide funding and what the cost will be for the borrower. This allows investors to compare the cost of financing to their expected return on investment, thus making the investment choice that best suits their needs. In this way, financial markets direct the allocation of credit throughout the economy-and facilitate the production of goods and services.

A recent example: Integrating existing EU financial markets

The European Union, with its single banking market and single currency, the Euro, has created Europe-wide financial markets and institutions. These markets use the Euro to facilitate saving, investment, borrowing, and lending. Euro-denominated stock, bond, and derivative markets serve all of the EU countries that use the Euro-replacing smaller, less-liquid, offerings and products that previously were available mostly on a country-by-country basis.

In addition, the Euro likely increases the attractiveness of Euro-based financial markets and instruments to the rest of the world. Within the EU, the Euro eliminates the cross-border exchange rate risks that are part of transactions between countries with different currencies. The Euro and integrated "Euro-based" financial markets and institutions should make the credit allocation process in Europe more competitive and more efficient in the long run.

What happens without well-developed financial markets?

In many developing nations, limited financial markets, instruments, and financial institutions, as well as poorly defined legal systems, may make it more costly to raise capital and may lower the return on savings or investments. Limited information or lack of financial transparency mean that information is not as readily available to market participants and risks may be higher than in economies with more fully-developed financial systems. In addition, it is more difficult to hold a diversified portfolio in small markets with only a limited selection of financial assets or savings and investment products. In such thin financial markets with little trading activity and few alternatives, it may be more difficult and costly to find the right product, maturity, or risk profile to satisfy the needs of borrowers and lenders.

More evidence that financial development matters

For further research on the topic, you may wish to review a 2002 study of financial structure and macroeconomic performance by Lopez and Spiegel, economists at the Federal Reserve Bank of San Francisco. With respect to the long-run relationship between financial systems and the economy, they reached the following conclusion:

We examine the relationship between indicators of financial development and economic performance for a cross-country panel over long and short periods. Our long-term results are consistent with much of the literature in that we find a positive relationship between financial development and economic growth.

Their findings also shed light on why financial development affects growth:

These results therefore indicate that the primary channel for financial development to facilitate growth over the long run is through physical and human capital accumulation.

Beck, Thorsten, Asli Demirgüç-Kunt, and Ross Levine. 2004. "Finance, Inequality, and Poverty: Cross-Country Evidence." NBER Working Paper No. 10979, December 2004.

Beck, Thorsten, Asli Demirgüç-Kunt, Luc Laeven, and Ross Levine. 2004. "Finance, Firm Size, and Growth." NBER Working Paper No. 10983, December 2004.

Demirgüç-Kunt, Asli and Ross Levine, editors. 2001, "Financial Structure and Economic Growth," Cambridge, Massachusetts, The MIT Press. See Introduction, Chapter 1.

Fabozzi, Frank J., Franco Modigliani, and Michael G. Ferri. 1994. "Foundations of Financial Markets and Institutions." Englewood Cliffs, New Jersey: Prentice Hall Inc., Chapters 1-3.

Levine, Ross. 2004. "Finance and Growth: Theory and Evidence." NBER Working Paper No. 10766, September 2004.

Lopez, Jose A. and Mark M. Spiegel. 2002. "Financial structure and macroeconomic performance over the short and long run." Federal Reserve Bank of San Francisco, Pacific Basin Working Paper Series. 02-05. September 2002. See Abstract.

Rose, Peter S. 1994. "Money and Capital Markets." Burr Ridge, Illinois: Irwin, 5th Edition. See Chapter 1.

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Please explain how financial markets may affect economic performance.

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Great question. The simple response is that well-developed, smoothly operating financial markets play an important role in contributing to the health and efficiency of an economy. There is a strong positive relationship between financial market development and economic growth.