Stock Market and the Economy

Discussing Stock Market always excites people. Tell people that you are a trader and people will start asking you for ‘tips’ immediately. Some people are nuts about stock market and some people just hate the idea of investing directly into stock market. The irony is both are right. Risk to invest money for short term usually outweighs the returns while investing for long term is probably a better idea. Still, stories of traders walking off with Corvette as a bonus or people jumping out of windows because huge losses are permanently imbibed on the psychic of modern societies. But why stock market is so important for economies?

Stock markets are hallmark of capitalistic economies. It is one of the most important system in Capitlism to raise money. Now, they can raise capital either by borrowing money from banks or floating bonds in the market or taking company public. When a company goes public, stock market comes into the picture. A company divides its worth into stocks. They sell those stocks on Stock Market to general public and raise capital. A stock holder owns part of the company, though, he/she doesn’t have any say in day-to-day running of the company. Later, those stocks get traded over and over according to news, rumors and performance of that perticular firm. But capital that, company raised initially remains the same.

Now as returns of stock market – over the period of time – are usually greater than interest rate of bank, more and more people invest money in the stock market. In developed economies percentage of population involved in stock market is quite high. For example, in US, more than 50% of people have their money in stock market while in China it’s mere 7%. So, it is quite clear that when stock market crashes lot of public equity vanishes. But this usually happens when market is floating high on the cloud nine of speculations. For example, the tech bubble of 2000.

Another factor that is related to above point is that as stock market lures people with higher results, greater part of household savings or pension plans is invested to stock market. Obviously, when market tanks, household savings and pension plans goes down the drain too!

The second factor to gauge importance of stock market is the value of tradable stocks. These tradable stocks doesn’t include equity held by government. As this value increases it affects economy more and more. In China, for example, value of stocks traded is only 25% of GDP. But in US, value is 150%. (In India this percentage is more than 100%)

Third, if stock market is on roll then it becomes easier for companies to raise money through the market and there by invest more. But when stock market crashes the investment decreases affecting economic growth on longer term.

Thus stock market is quite important to economy but without these above factors, it doesn’t affect economy as much as it is believed. That is, stock market melt down in China won’t be as detrimental to Chinese economy as it is predicted. But swings in stock market have puissant effect on public psyche. So, it is understandable that when stock market dives everyone is talking about economy going down but it doesn’t have to be so.