The Dangerous Gap Between Wall Street and Main Street

Shah Gilani|September 13, 2024

There’s an important idea every investor needs to understand.

The stock market and the economy are two completely different things.

While many years ago they worked together to paint a clear picture of the health of the U.S…

Those days are long gone.

The markets and the economy are often so far apart it can seem like what’s up is down and vice versa.

They operate on different planes, driven by distinct forces. That’s why they seem to defy logic at times.

And knowing how the market and the economy diverge… and converge… will help you make smarter investment decisions.

That’s about to become critical…

So Far Away

The economy is driven by real-world activities and fundamental factors such as consumer and government spending, business investment, monetary spending (the Fed), and global trade.

The stock market enables individuals to own shares of ownership in companies. It is influenced by factors such as corporate performance, market sentiment and expectations, economic indicators, the Fed, and geopolitics.

One of the most fascinating – and frustrating – aspects of the market is its ability to diverge from economic realities.

It’s why we see headlines like this…

The stock market often moves in its own direction, driven by expectations of future outcomes rather than current economic conditions. This divergence is influenced by narratives and speculative behavior.

For instance, during a period of economic slowdown, stock prices might still rise if investors are optimistic about an economic recovery or if they believe certain sectors or companies will outperform.

Narratives play a crucial role here. Investors and the media can create compelling stories about the future, which can lead to stock prices moving independently of current economic fundamentals.

A promising technological breakthrough or a new policy initiative can drive stock prices up, even if the overall economy is struggling.

Speculative behavior can also cause the stock market to diverge from the economy.

During periods of speculative euphoria, investors might drive prices up far beyond what economic fundamentals would suggest. Conversely, a market panic will cause stock prices to plummet regardless of underlying economic conditions.

The opposition can make investors dizzy… or confused about the best moves to make for their portfolio.

Come Together

Eventually, the stock market’s divergence from the economy tends to converge back to economic realities.

It’s usually triggered by significant changes or trends.

Consumer spending is a prime example…

When consumers cut back, businesses face lower revenues and profits. This slowdown often leads to lower stock prices as investors anticipate reduced earnings and a weaker economic outlook.

For example, during a recession or economic downturn, consumer confidence typically wanes, leading to reduced spending.

Companies may experience declining revenues and profits, prompting investors to reassess their stock valuations. This can lead to a significant drop in stock prices, aligning the market more closely with the deteriorating economic conditions.

Now, the opposite is also true.

During periods of robust economic growth, stock prices often rise in tandem with economic indicators.

Strong GDP growth, low unemployment, and rising corporate profits generally contribute to higher stock valuations. Investors are likely to drive stock prices up as they anticipate continued economic strength and increasing corporate earnings.

For instance, during the late 1990s tech boom, the stock market soared as investors expected significant advancements and profits from technology companies.

This period saw the stock market’s optimism align with a period of rapid technological advancement and economic growth.

This feedback loop works in both directions.

Taking Stock

The stock market can also influence economic conditions…

• Rising stock prices can influence consumer confidence and create a wealth effect. When people feel wealthier and more secure in their financial future, they tend to increase spending, which can stimulate economic growth.
• When stock prices are high, companies can raise capital more easily through equity offerings. This can lead to increased investment and expansion, which positively impacts the economy.

Of course, it can go the other way as well…

A sharp decline in the stock market can reduce consumer and business confidence, leading to decreased spending and investment, which can slow economic growth.

Here’s the bottom line…

While the stock market and the economy are connected, they do not always move in sync.

The stock market reflects investor expectations and speculative behavior… which in turn doesn’t always reflect the economic reality.

But at times economic fundamentals tend to prevail, bringing the stock market back in line with economic conditions.

As I mentioned, when consumer spending starts to slow or other significant economic shifts occur, the stock market often adjusts to reflect these changes…

Which is something I see coming down the pike.

With a record $5 trillion in credit card debt… a reduced savings rate… and slower wage growth… we will see consumer spending slow down. The market will be forced to adjust to that economic reality.

I’ll talk more about this next week… what state consumers are in, how to gauge spending trends, and what the market will do when economic realities overwhelm upbeat narratives.