Why does the stock market lead the economy?

The stock market is often considered a leading economic indicator because it reflects investors' expectations about the future health of the economy. When investors believe that the economy will perform well in the future, they are more likely to invest in stocks, driving up stock prices. Conversely, when investors are pessimistic about the future of the economy, they may sell stocks, leading to a decline in stock prices.

There are several reasons why the stock market may lead the economy. One reason is that the stock market represents the expectations and opinions of investors, who may be well-informed about economic conditions. These investors may have access to information that is not yet widely known or reflected in economic data.

Another reason is that the stock market can affect the economy through its impact on consumer and business confidence. When the stock market is doing well, consumers and businesses may feel more confident about the future and be more likely to spend and invest. On the other hand, a decline in the stock market can lead to a decrease in confidence and a reduction in spending and investment.

One example of the stock market leading the economy is the stock market crash of 1929, which preceded the Great Depression. In the late 1920s, the stock market experienced a period of rapid growth, fueled by speculation and easy credit. However, in October 1929, the stock market crashed, leading to a period of economic contraction and high unemployment.

Another example is the stock market's response to the COVID-19 pandemic in 2020. In February and March 2020, the stock market experienced a sharp decline as investors became concerned about the economic impact of the pandemic. This decline preceded a period of economic contraction as businesses closed and unemployment rose. However, the stock market eventually rebounded, reflecting investors' optimism about the prospects for a recovery.

Other examples:

The dot-com bubble of the late 1990s and early 2000s: During this period, the stock market experienced a period of rapid growth as investors poured money into technology and internet-related companies. However, the bubble eventually burst, leading to a sharp decline in stock prices. This decline preceded a period of economic contraction and job losses in the technology sector.

The 2008 financial crisis: In the years leading up to the financial crisis, the stock market experienced significant growth as investors poured money into the housing market and other sectors. However, when the housing market collapsed, the stock market followed suit, leading to a period of economic contraction and high unemployment.

The dogwalker and the dog on the leash analogy. The noted fund manager and author Ralph Wagner described the complex relationship between the economy and the stock market:

“There’s an excitable dog on a very long leash in New York City, darting randomly in every direction. The dog’s owner is walking from Columbus Circle, through Central Park, to the Metropolitan Museum. At any one moment, there is no predicting which way the pooch will lurch. But in the long run, you know he’s heading northeast at an average speed of three miles per hour. What is astonishing is that almost all of the dog watchers, big and small, seem to have their eye on the dog, and not the owner.” how the economy and stock market play off of each other.

A dog on a leash is similar to the stock market in that it is being guided by its owner, the economy. The owner can pull on the leash to guide the dog in a certain direction, just as economic indicators such as GDP, inflation, and employment can act as "leashes" on the economy, guiding it in certain directions. For example, if GDP is growing, this may lead to increased consumer confidence and spending, which can further drive economic growth.

With everyone's eyes on the dog's path, perhaps heading left to take a quick bathroom break on fire hydrant, they might miss that the owner, or the economy, is guiding him in a different long term direction. The dog might be in front of the dog walker, but the dog walker is guiding the dog. It is a complex relationship indeed.