Remember ’87 market crash

The question that whether the stock market can predict an economy’s growth is widely debated. Those who support the market’s predictive ability argue that the stock market is forward-looking and current prices reflect the future earning potential, or profitability, of corporations. Since stock prices reflect expectations about profitability, and profitability is directly linked to economic activity, fluctuations in stock prices are thought to lead the direction of the economy. There are many reasons not to trust the stock market as an indicator of future economic activity. Pearce (1983) argues that the stock market has previously generated “false signals” about the economy, and therefore, should not be relied on as an economic indicator. Another reason why sceptics don’t trust the stock market as an indicator of the economy is because of investors’ expectations. Critics reason that expectations about future economic activity are subject to human error, which in many cases causes stock prices to deviate from the “real” economy. Since investors do not always anticipate correctly, stock prices sometimes increase before the economy enters into recession and decrease before the economy expands.

As a result, the stock market will often mislead the direction of the economy. In conclusion, the big difference between market and economy is that market is forward looking, and its unexpected events that primarily drive future stock prices. A crash in stock market can devastate economic growth.