What is the relationship between share prices and the economy, and why is this?

Question

What is the relationship between share prices and the economy, and why is this?

Answer 1

during times of recession (economic slowdowns) shares in the stock market tend to go down.  During recession GDP meaning total production goes down.  Companies produce less so they make smaller profits.  Demand for product goes down as people have real money to spend. Consumption accounts for 2/3 of GDP so a change in consumption have big consequences on GDP.  If people are buying less products and services then companies produce less and some even suffer big losses.  Take GM for instance.  A lot of people are not buying big trucks anymore (GM bread and butter) so GM is suffering astronomical losses, and their share price is down in the mud.  Another little fact you want to consider is that during the great depression the stock market decline around 80%.

Now during economic booms, shares in the stock market go up in price.  Companies make a lot of money (or are expected to make a lot of money) consumption goes up, consumer confidence goes up, unemployment is low, GDP goes up.  Look at what happened in the mid to late 90's when the U.S. had the tech boom.  Shares on stock were astronomically high.

There is also a relationship between inflation and expected inflation on the stock market and a relationship between expected returns, you might want to look into the theory of asset demand which is also called portfolio theory.