The question of whether the stock market reflects the economy is a very old one. Developments in the stock market sometimes seem disconnected from the rest of the economy, especially during recessions. In the past, however, stock price changes can actually describe certain fluctuations in key economic indicators.

Can the stock market reflect the economy?

To a certain extent, it does. Rising stock markets are often associated with a stronger economy, which increases investor confidence. Investor confidence in the stock leads to increased buying activity, which in turn helps drive the stock price higher over the long term. Those who invest in the stock market can make substantial profits when the value of the stock rises.

When people are confident they can afford more, they tend to increase consumer spending. Companies that sell these products and services choose to manufacture and sell more due to greater customer demand, resulting in higher profits.

Likewise, losses in the stock market reduce the value of personal and retirement accounts. When the value of consumers' portfolios declines, they are more inclined to spend less. Businesses are suffering as spending falls, especially those that sell non-essential products and services, such as luxury cars and entertainment, that consumers may abandon when cash is tight.

Commerce and Stock Exchange.

Developments in the stock market can have a variety of effects on companies. Changes in stock prices affect a company's market valuation, which in turn affects the company's market value. The higher the company's share price, the higher the company's market capitalization, and vice versa. The market value of a company can be important when considering a merger or acquisition that includes stock as part of a transaction.

Developments in the stock market also affect a company's cost of capital. When calculating the average cost of capital, companies must analyze both the cost of equity and the cost of debt. This number is used in various analytical situations. The cost of equity will increase in direct proportion to the predicted stock market development. As the cost of equity increases, the present value calculation becomes less accurate because the company must use a higher discount rate to achieve the same result.

The Bottom Line.

A favorable appreciation in the value of a company's stock may also renew interest in the company or industry. This has the potential to drive revenue growth through sales and attract investors. With that in mind, it's safe to assume that the stock market mirrors the economy to some extent.