Are Market Indexes Providing a Misleading Portrait of the Economy?

Stock MarketOne of the simplest methods of understanding the current financial market is through analysis of market indexes and comparing their values to past reference points like the 52 week high and the 52 week low. Many investors have had their eye on these market indexes lately, confused about why they seem to be doing so well while the economy itself continues to slump, and the inequality gap continues to widen.

For example, many market indexes are still valued within 10% of their highest value in the last year, giving the illusion that the market is still thriving. Deeper analysis, however, reveals a more accurate reflection of today’s economic reality: by looking at the components of an index, we can see that their values mask many downturns in the market and do not represent the economy as a whole. Managing a stock portfolio only based on this information is a recipe for failure, as these market indexes provide an incorrect snapshot of the economy.

The Disconnect Between Market Indexes and the Economy’s Reality

When comparing the statistics of the stock market and the overall economy, to say that one is a misleading representative of the other does not capture the complexity of the issue. It is well known that there are many volatile, complicated connections between the value and practices of the various organizations, institutions, and trades that comprise the top of the world economic market today. One might assume that an index is designed to amalgamate all of the complexity of the stock market and provide an accurate representation that can be trusted for making management’s decisions in terms of your stock portfolio. However, indexes should be understood on their own terms: in simplified terms, they are based not on an average, but a weighted average, such that larger companies comprise a larger portion of the market index’s value.

Of course, the calculations that are used to create these indexes are far more complicated than this. Nevertheless, we can already understand where they may begin to misrepresent the bigger economic picture. When bigger companies and larger stock values are doing well, they may mask the fare of dozens of smaller companies that are struggling, even if their collective struggle is more intensive than the larger company’s success. Consider the current situation: today: the most successful and profitable companies are in pharmaceutical industries and information technology, and the industry giants have been an extremely positive force within the market today. In the manner in which the market index is calculated, the few top companies will often account for over half of the market index’s value, which is clearly disproportionate to the other companies represented through the index.

New Ways of Understanding Our Economy

In discussion of the changing economy, even scholars and expert analysts make the mistake of understanding the stock market as a valid microcosm of the economy – therefore, it is no wonder that the general public struggles to understand the subtle distinctions between the two that are masked by strategic statistical analysis. We should take a moment to consider why these market indexes are calculated to indicate a booming market while the economic realities are bleaker: is it a motivation for stimulating new investors, or a purposed misrepresentation to keep morale high among the general public? Whatever the case, it is important to have a plethora of modalities for measuring the values of particular stocks, and to not develop a dependency on one method – surely, each index or marker has its own benefits and downfalls, exaggerating some information while distorting other critical details. Be sure to know the correct option strike prices and expirations of stocks if you are considering covered call writing as an investment option.

Jeremie Brenton is a freelance blogger with an interest in technology and economics. You can contact him at jeremie.brenton@gmail.com or add him on Facebook.

[Please note that guest posts represent the views of the authors and not necessarily that of mine]

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