How Markets Interact, Part 4: Stocks

The stock market is the glamour girl of financial markets. It's the one that gets the most attention and press. But actually the stock market is less important to the economy than both the bond and currency markets. Even so, many people are interested in the stock market as they see it as an indicator of the state of the economy, not to mention they may have some money invested in it.

The stock market exists, interestingly, as a side result of companies needing to raise capital. When a new, growing company decides it needs to raise funds for growth, it can make arrangements to "go public," that is essentially sell some or most of the company to the public in the form of "shares" which each represent a tiny bit of ownership of the company. This "initial public offering" of shares, or IPO, raises a lot of money for the company, which it reinvests in itself. But the company's status has fundamentally changed. It has lost its innocence, so to speak, and now the shares it sold can be traded on the open market. The price of those shares show the public's perception of the value of the company at any given time.

The stock market's overall valuation is a generalization of all the values of all the stocks which comprise it. These values are indicated by published indices--like the Dow Jones Industrial Average, the S&P 500 and the Nasdaq indices. These index levels are determined, when all is said and done, simply by the buying and selling pressure on the shares which make up the stocks in them. News, profit expectations, economic outlooks, world events and other things affect stock buying and selling, but it is the pure and simple buying and selling which determines price.

Stock prices respond favorably to low inflation and low interest rates, as these things reflect the availability of money to be spent in the economy on many things, including, not coincidentally, buying stocks!

Since bonds also respond well to low inflation and interest rates, bonds tend to lead stocks and stocks tend to follow bonds in the same direction. This is the normal healthy relationship between them. There is a big exception to this, however. In a deflationary environment, stocks and bonds tend to move in opposite directions.

I'll leave it here for now and try to summarize in the next post.

Next up: Tying it all together