Explanation and Data
Since the S&P 500 tracks the performance of the largest public companies in the United States the S&P 500 indirectly reflects the economy. That is, if the economy in a state of growth and to what degree or is the economy in a state of contraction.
S&P 500 & Economic Indicators Table
Macrotrends, Worldbank, Statista
Why does the S&P 500 generally reflect the economy? Here’s how it works from a high-level overview.
A company’s value is directly tied to their earnings, so, if company earnings go up, likewise, the value of the company goes up. On the other hand if company earnings go down then the value of the company goes down. But where do these earnings come from?
Typically, companies increase their earnings by selling more of their products. If a company is able to sell more of its products this also means that consumers are willing to buy more and have the ability to do so. Consumers typically increase their spending when times are good and decrease spending when times are hard. Since company earnings and consumer spending are closely linked, and the value of a company is tied to its earnings, following the change in company value can give us indirect insight into what’s going on.
Why the S&P 500 index?
Watching just one company wouldn’t provide us with an accurate sample to make insights about the economy. Instead, we would want to look at the values of all businesses in the United States. The problem with this is twofold. First, most businesses are private so their values aren’t readily available. Second, these businesses aren’t being valued every day so their value is more in question.
To solve this, we can look at a sufficiently large group of companies that are both publicly traded and revalued frequently. This is where the S&P 500 comes in as a useful metric. The S&P 500 is a sufficiently large group of companies that are publicly traded and also likely to be revalued frequently.
Other Economic indicators
As you can see from the table above, there are a number of different ways someone may want to measure the state and health of the economy. Depending on the question being asked the indicator used to answer the question may need to change.
S&P 500 vs GDP
Macrotrends, Worldbank, Statista
If you are looking for an exact measure of the economy, as in the total value of all economic activity, then you will likely want to use the gross domestic product.
Gross domestic product (GDP) is a measure of the total market value for all goods and services produced within a country over a period of time. Or another way to say it, what’s the value of everything a country produced within its borders over a month, 3-months, a year, etc.
GDP is useful not only because it tells you the total economic output for a country but it also gives you the value of the economy. For example, if a country has a GDP of $20 trillion this means it has an economy worth $20 trillion since this is the total value of all goods produced within the country.
GDP is a direct precise measure of an economy whereas the S&P 500 reflects the economy indirectly and only gives an indication. So why do people look at the S&P 500 as an indication of the economy? People reference the S&P 500 as an economic indicator because GDP is very slow to be measured.
S&P 500 vs Wage Growth
Macrotrends, Worldbank, Statista
While knowing the total value of economic output (GDP) or the direction of values of large companies may be useful to assess the big picture. What about understanding the economy on an average person basis?
When looking to see if an economy is improving for the average person, wage growth would be a good economic indicator to use. Wage growth is simply the percentage increase in annual earnings for full-time employed workers. That is, if the average person is out there every day contributing to society. Is the total contribution of all workers like them coming back around to lift their average wage?
More simply, wage growth is the impact of an economy on the average worker.
Why is the S&P 500 still as important as wage growth? In today’s work environment most worker’s retirements are in 401Ks which invest in the stock market, typically an S&P 500 type index fund. This means that the money workers are relying on to retire is directly tied to the performance of the S&P 500.
Additionally, it is very likely that eventually the money earned from investments, passive income, will be larger than the money they receive from employer wages, active income.
S&P 500 vs Inflation
Macrotrends, Worldbank, Statista
For well establish economies inflation isn’t a usual area of concern. However, that doesn’t mean it’s unimportant to monitor. Inflation is an expansion of the money supply of a currency, resulting in the decreased purchasing power of each unit of currency.
If an economy is healthy and growing it should have a small amount of inflation, typically between 1-2%. Even this small level of inflation though impacts everything in an economy from wages, to investment, to cash in the bank. This means for someone to get ahead in an economy with inflation, they must at a minimum outpace the rate of inflation.
Now If inflation takes off and rises to high levels, this may be an indication of economic uncertainty and instability. Ultimately high inflation jeopardized the growth of an economy on every level as price uncertainty disincentivizes commerce.
Consider the impact of inflation through an example. Say you started a full-time job paying a $50,000/year salary. At the beginning of the job, everything is going well and you are happy with what you’re making. Now let’s add in high annual inflation of 12%. By the end of the year, your paycheck still says the same amount but you’re actually making the equivalent of $44,000. In other words, inflation gave you a $6,000 pay cut. Now spread this equation across all wage earners in an economy and it’s easy to see the impact.
Additional useful resources: 5-Year average return of S&P 500
Additional useful resources: 10-Year average return of S&P 500