Because companies that make up the stock market account for trillions of investment dollars, employ millions of people and garner a lot of headlines, it’s easy to believe that the stock market and the economy are essentially the same.

When the stock market is up, you may infer the economy is doing better. Similarly, when the stock market is down, you may infer that the overall economy is doing worse.

Such beliefs might be mistaken.

How are the stock market and economy different?

While the two are interrelated, they have key differences.

1. Time period. Note that economic measures relate to the past and can lead up closely to the present. Meanwhile, the stock market is thought to be forward-looking, meaning some investors believe it can anticipate economic conditions that may occur in the future.
2. Size. While the US economy’s size is over $21T, the stock market (here we use the S&P 500, SPY, as a proxy) is at present worth approximately $40T, so nearly 2x bigger. However, the stock market’s value can fluctuate significantly. In a downturn, the stock market’s value can converge roughly to the size of the overall economy. Noted investor Warren Buffett uses a ratio of market cap to GDP, called the “Buffett indicator,” to assess whether a market is over or undervalued.
3. How They Are Measured. The two entities belong to entirely different categories. The stock market is measured at a specific *point* in time. For example, 4:30 p.m., January 4, 2021. The other — the economy — is measured during a particular *interval* of time. For example, from January 1 to December 31st of the year 2021. This distinction is commonly referred to as the distinction between a stock (not to be confused with the equities that comprise a stock market) and a flow.
4. Growth vs Returns. It’s also important to remember that GDP growth does not necessarily correspond to positive stock market returns. While the two can go together directionally, there are instances when the two have diverged. In some years, the stock market has gone up when GDP growth was negative, while in other years, the stock market has gone down while GDP growth was positive. In fact, there may be little correlation between GDP growth and stock market returns.

Here are some statistics that underscore the difference between the companies that comprise the S&P 500 and the overall economy.

1. Number of employees. As of 2022, the United States overall has over 155M employed persons; the companies in the S&P 500 employ approximately ~⅙that number.
2. Number of companies. As its name indicates, the S&P 500 (SPY) is comprised of 500 companies, while in the aggregate there are thousands of publicly traded companies; just under 4,000are listedon major US exchanges. Including companies not listed on exchanges, there are over 30M companies (~8M sole proprietorships) in the U.S., so publicly traded companies account for a small percentage of the overall number of companies. Also note that the overall economy includes both the private *and* public sectors, with the private sector comprising ~80% of the economy.
3. Revenue. Note that stock market capitalization is a multiple of the annual revenue generated (or projected) by the companies in that market. Currently, the stock market (S&P 500) trades at over 3x Price/Sales, which implies that revenues generated by companies in the S&P 500 are over $10T. Again, compare that to annual US GDP ~$21T, which is nearly 2x.

Why it’s important not to confuse the two

Given that the companies in the S&P 500 (or any stock market index) are part of a subset of the overall economy, trends for that subset can conceivably diverge from the rest of the economy.

Consider a scenario where the S&P 500 companies gain market share from the smaller companies that are not in the index. In that scenario, the S&P 500 companies could perform better than the overall economy.

More importantly, as noted above, the economy and the stock market, at times, can decouple. While the economy is doing poorly, in a recession for example, stock markets can sometimes rebound.

How can this be? It’s important to grasp that the stock market is forward-looking. In the view of some investors, the stock market actually serves as a leading indicator for the economy.

That means the stock market *anticipates* improving conditions, sometimes months ahead of when conditions actually start improving.

And in times when the economy is performing well, the stock market can, conceivably, underperform. That’s because the market anticipates problems and a slowdown in growth.

So, just as you do with earnings reports and individual companies, look to macro-related headlines to provide clues about the future of the overall economy.

And, as professional investors do, look at the stock market and stock sector reactions — over the short-term and intermediate-term — as these, too, can provide clues about the underlying economy.

You can find news and information about the S&P 500 under the ticker SPY and other such indices on our platform at Tornado.

Originally published on Tornado.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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