FAQ 3: Do Indexes measure the Economy?
Um, yes, but mostly no. They measure the economy in the same way that a big-appetite can measure the health of a person.
of an entity, be it the entire Earth, a group of countries, single countries or even smaller entities like cities or rural towns, is like an #Environment
of the same entity, but it focuses on how our decisions affect each other within the entity. In prehistoric times the economy was things like a freshwater stream, a berry bush, a fruit tree, some predator and prey animals, you & your family, and who gets to have what. We can assume they had a net positive economic system because we are here today in greater numbers.
Almost anybody who reads this can, in a moments thought, conclude that the price of a stock in an #index
has very little to do with their personal experiences in the economy. If you try to imagine that every private business (not traded on an open market like #NYSE, #NASDAQ, or #OTC
), from the next-door neighbor's side-hustle that is only a #business
on their tax forms such as a Schedule C sheet or a number in the Other Income
box on the main page of their 1040
, to #companies
as big as Cargill
, it seems obvious that most of the Economy isn't part of the #stock
. Clearly, private companies cannot possibly be measured by any index of any market. They are all certainly part of the economy. Some parts of the economy defy all aggregate measurement, like when the excess heat waste of buried pipes of a manufacturing plant makes the land above them ideal for a Northern farmer to build a winter tolerant tomato farm under glass. Some parts of the economy we can measure, but because of power in the wrong hands we don't, like the negative cost of pollution on all of society and the environment versus the cost of responsible handling of the same waste product, be it a smokestack of a coal-fired electric power plant or a pig-shit lake running off into a freshwater stream people get their drinking water from. The economy is so big and detailed, and an index is so focused and simple that it should be obvious that it does not measure the economy.But it does measure something!
Just like a big appetite for food can show that a baby is healthy, or a person in the hospital is recovering, an index can tell something about the economy. The indexes are aggregating price changes in the stock markets. #Price
changes in the stock market are in general changing because at least two people have simultaneously thought, that's too low & that's too high, and had the ability to transact in that companies stock. We can have wishful thoughts about that price meaning the worth of that company (Market Capitalization), but it's not too much so; mostly its desire-driven based pricing on the perception of future earnings potential. When a company first issues the stock in a way that the "public" can buy shares (to become Outstanding Shares), the buyers are handing the company cash to do projects for profit in exchange for some ownership claim to the company. Most of the public trading has nothing to do with the day to day operations of the company. If they want to launch another big project and want to issue more stock to fund it (selling Treasury Stock), they would care greatly what the current price of their stock is selling at. It might seem like everything I'm writing proves indexes are not measuring the economy, but that connection between sentiment and price is an indicator. Since goods and/or services a company offers are where it's profit & potential profit comes from, and desirable products and services are a fundamental component of every economy, an index going up hints at a bright future for the economy, in as much as the part of the economy that is publicly traded in the stock market. Though that segregation of public/private exists, both the company types have equal access to the whole economies customers, so there is a connection to the economy from an index albeit a sentimental one where people back their opinions with their own money.
Please note that price changes don't directly mean the underlying company is worth more or worth less, it just means that the last buyer-seller combination has agreed to trade money for a tiny slice of ownership at that price per share. For example, the day I was writing this, Nike had great earnings news come out the day before
and there was a flood of shares changing hands
; over 1% of the companies outstanding shares changed ownership. (lolz, over 1%!!!
) If a company like Nike has a really monstrous day they might have up to 4% of the ownership change hands. Some of that is automatic trading in weight managed funds, and some of that is day trading speculators who will buy and sell in the same day or week. The volume of the shares being traded is fairly important but the news does not have a way to adjust the fuzzy logic level of certainty of the index according to volume. You need to keep that in mind when evaluating what an index is saying compared to other metrics. Seeing a cloud in the sky doesn't mean you need to carry an umbrella.