The Relationship between Stock Markets and GDP: USA
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THE RELATIONSHIP BETWEEN STOCK MARKETS AND GDP
The common conception is that Stock markets and Gross Domestic Product (GDP) are related. GDP a measure of a country’s productivity, which we all know and defined as the “value of all goods and services produced in the country” is a commonly used indicator to gauge the health of a country’s economy. So that the more that a country produces, the more the people spend, the happier the economy and this translates to earnings. So that when a country earns, it means that its businesses – to include the corporations listed in the stock market are earning – sharing corporate dividends to shareholders and or throwing in money for expansion. In this scenario, the positive growth of GDP translates to a happier state in the stock market. For stock market players, common sense would suggest that a positive outlook of the economy, using GDP as an indicator, is used as a good signal to buy stocks. This of course also means that a negative economic forecast may hold off some stock market investors from spending. In other words, GDP when it rises contributes to a positive expansion in the stock market in the same way that when GDP decreases, stock market also contracts. The above arguments are intuitive and commonsensical assumptions of GDP and stock markets. Empirical studies however dispute the arguments and provide us a counterintuitive explanation of GDP and its relationship with stocks and vice versa.
A paper by Jain and Kranson (2009) of Vontobel Asset Management Inc. and which is appropriately entitled, “The Myth of GDP and Stock Market Returns,” reviewed a study of 16 developed countries from 1900 to 2000 conducted by Dimson, Marsh and Stanton and updated by Ritter up through 2002. Both studies indicated that over the long-term there is no relationship between GDP and stock market. One of the plausible reasons put forward by Jain and Kranson (2009) is that GDP reflects sales of goods and services produced in the country whereas stock markets are measured in terms of profitability. Sales do not necessarily translate to profitability and besides profits of listed companies may not be raked from the home country but rather from its host countries all over the world as in the case of multinational companies. The other reason is that the stock market is just part and parcel of the economy wherein which its activity does not and cannot influence the broader and more complex economy as measured by the GDP.
A closely related study which ridiculously combined the disciplines of astronomy and the economy was conducted by Modis (2007). He studied the correlation between sunspots, the US stock market as measured by the Dow Jones Industrial Average (DJIA) and US GDP with data from the 1920s to 2000. He found out that there is a correlation between sunspots, the DJIA and GDP. Further he superimposed his data by leaving out sunspots to correlate DJIA and GDP. He found out however that the correlation coefficient between DJIA and GDP is r = 0.5, which indicates that there is no significant relationship between the two. The findings of Modis (2007) and the study of Dimson, Marsh and Stanton and Ritter strengthens and supports the hypothesis that a significant correlation between GDP and stock markets is a myth.
But does the relationship between the two variables changes when GDP is replaced by stock market as the independent variable as in the statement advancing the hypothesis that ‘stock market affects economic growth’? When stock market expands there is a positive response in the growth of the GDP but when the market contracts, it does not necessarily result to a similar reduction of the GDP because the stock market is just one of the many figures used in the computation of GDP. Levine(--) maintains that stock markets may affect the economy because stock markets offers the investor the leverage of liquidity, that is, investing in stocks is an attractive option for investors who want to gain profit and at the same time freedom to enter and exit very easily and conveniently as he pleases. He adds that the characteristic liquidity of stock market, with its less risky and profitable nature makes it even more attractive to investors. He supported this view with empirical evidence of 38 countries from developed and developing countries with liquid and illiquid markets from 1976 to 1993. Results show that countries with very liquid markets such as Japan, United Kingdom, United States and Australia have stronger economies that grew faster over the next 18 years; while countries such as Colombia, Greece, Norway and Spain whose markets are very illiquid have slower economic growth. Using multiple regression analysis and after controlling variables such as “ fiscal policy, political stability, education, the efficiency of the legal system, exchange rate policy, and openness to international trade,” stock market liquidity is a reliable indicator of future long-term economic growth. Levine (---) however emphasized the insignificant relationship of market size and volatility and economic growth, he warned that “market size does not predict economic growth and volatility of market stock price does not also predict poor economic performance.”
Jain, R., Kranson, D., 2009. The Myth of GDP and Stock Market Returns. [online] Available at: <http://www.virtus.com/vsitemanager/Upload/Docs/6141_GDPwhitepaper.pdf> [Accessed 28 April 2011].
Levine, R., n..d. Stock Markets: A Spur to Economic Growth. This article is based on 12 papers presented at a World Bank conference, "Stock Markets, Corporate Finance, and Economic Growth," organized by Asli Demirg-Kunt and Ross Levine. Also available at http://www.worldbank.org/fandd. [online] Available at: http://actrav.itcilo.org/actrav-english/telearn/global/ilo/equity/fdstock.htm. [Accessed 28 April 2011].
Modis , T., 2009. Sunspots, GDP and the Stock Market. Authors Copu. Also available at www.sciencedirect.com[online] Available at: <http://www.growth-dynamics.com/articles/sunspots.pdf> [Accessed 28 April 2011)