1. Money

Stock Market and Economy – Close, but Not the Same

Long-Term Trends May Foretell Direction

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As I have noted before, the stock market is not the economy, nor is the economy the stock market.

However, the two are related in many ways. Some of the same indicators are important to both: jobs, housing and so on.

The problem arises when investors mistakenly assume that because the stock market is soaring or crashing that the economy should be performing likewise.

It is true that the stock market can foretell changes in the economy, but you must remember the stock market revalues itself every minute (in truth, every second or less) the market is open.

Short-term and very short-term gains or losses in the stock market don't tell you much about the economy - although unexpected good or bad news can send the market in a new direction, at least for a short time.

Over the short term, stocks respond to the influences of supply and demand as buyers and sellers struggle to get the best price for their trades.

This is nothing new. The economy or virtually any economic indicator can cause a spike or severe dip in the stock market, but sometimes people will mistake these daily fluctuations to represent something other than the basic struggle between supply and demand.

However, when you look over the long-term trend of major stock market indicators, they can foreshadow what the economy might do in the future. Remember the stock market is always concerned about the future even though traders may struggle to find the best price on a daily basis.

Long-term investors buy stocks based on what they perceive will be its future value. That future value may grow or decline based on what the economy is doing.

The thought is that if investors are willing to buy stocks and continue buying them as prices increase over the long term, it is a sign they have confidence in the economy and believe for stocks will be of value compared to the worth of the stock at some point in the future. The prices they pay today will prove a good investment over the long term.

The stock market is not perfect predictor of economic growth or decline, but it has generally been true the sustained period of growth in the stock market usually is followed by a similar growth in the economy over time.

What does this mean for the long-term stock investor? It means that long-term investors should keep an eye on the economy and economic trends: are they up or are they down and use this information to help them decide if their estimate of the future value of stock is still valid.

At the end of the day the only thing that really matters to long-term stock investors is the difference between the price they pay today and the price they anticipate the stock will be at some point in the distant future. While estimating the future value of anything is a tricky job, long-term stock investors the fairly analyze the company, is positioned in the market and its competitors will have a good understanding of what the stock is worth per share now and should be in the future based on whatever economic assumptions the person uses.

As with all things related to the stock market, long-term investors need to keep an eye on the economy and watch the trends. If the trend is down over sustained, beware; if the trend is up, it may be a sign that the economy is recovering or growing.

Long-term investors deal in facts, not feelings. Don't let a short-term spurt or dip in the stock market make you decide to buy or sell, when the most sensible thing most investors can do is sit tight.

Even if the stock market is trending down, that does not mean your stock is doomed to follow. Some stocks do well when the economy is not performing.

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