Why The Stock Market Matters Very Little

It is one of the staples of news programs. Every evening it is reported that the Dow Jones industrial average is up or down a certain number of points. This could lead one to assume that the stock market plays a very large (indeed, dominant) role in the economy. But this is not the case.

In the United States, the country where the stock market plays the largest role in the economy, about 9% of all capital is raised through the equities market. The vast majority of capital is raised through the debt market. The most important financial elements in the economy are banks and the bond market. Bank loans account for 40% of all capital raised in the United States. Bonds account for an another 35%. Thus, together bank loans and bonds account for 75% of all capital raised. The other 16% of capital raised is accounted for through finance companies and such.

In other industrialized nations, the stock market plays a smaller role than it does in the United States. In developing nations, it plays an almost insignificant role. Some will argue that because the Efficient Market Hypothesis is true, that the current stock price is a reflection of the present value of all future earnings, that somehow the stock market is a barometer of the future economy. This is not so. A very small percentage of firms are listed on stock markets and of those that are listed, the stock market may not be their main (certainly not only) method of raising capital.

So, instead of the stock market, perhaps the rate of inflation (or perhaps the budget deficit and the price of gold - an indicators of future inflation) or the rate of economic growth should receive more attention. I highly doubt that will be the case because the stock market provides new news everyday - it's ups and downs are interesting to report. But in reality the fluctuations of the equities market are not the most important variable which affect the broader macro economy.

Source for the above statistics: Fredric S. Mishkin, The Economics Of Money, Banking And Financial Markets