Effect of Market Expectations

The economy affects the stock market in many ways, and the government produces lots of weekly, monthly and quarterly economic data to track and study it. As we have discussed in another section of this website, among the most important indicators are: inflation (the increase and decrease of prices), the gross domestic product or GDP (the sum of goods and services produced in the country), the unemployment rate (the number of people who can’t find jobs), and the discount rate (the rate set by the government that eventually affects the interest rates your parents pay to borrow money). These economic indicators are all related in one way or another.

Stock Markets React to Unmet Expectations

The stock market continuously adjusts itself by reassessing the value of stocks based on any new financial information it gets. The stock market also adjusts based on the guesses of financial experts on what the government’s economic data and the government’s actions will be.

As an example of how these indicators affect the stock market, let’s examine the effect of the unemployment rate. If, for example, investors think the unemployment rate for the next month will be 5% and it eventually proves to be 4%, there is a pretty good chance that the S&P 500 will go down. As we discussed earlier, the stock market might go down in this case because a lower unemployment rate could trigger inflation, a result of more people having money to buy more goods and services. However, if the unemployment rate comes in at 5% as expected, a stock market index like the S&P 500 will probably not change much.

Real-life evidence of how expectations affect the market can be found, once again, in our earlier example of how the CPI affected the stock market on April 14, 2000. On that day, the Dow and the NASDAQ Composite dropped sharply because the newly released CPI showed a 0.7% increase. The major problem was not that the CPI increased, but that people expected an increase of only 0.5%. Here is how the April 17, 2000 issue of Investor’s Business Daily reported the drop in the market:

Investor’s got a rude awakening Friday. The consumer price index jumped 0.7% in March, the biggest gain in almost a year, casting already-weak stocks into another freefall. The surge was worse than the 0.5% rise most analysts expected.

As you can see, investors were disappointed that inflation was climbing faster than expected, so they pulled their money out of the stock market. Of course, this helped cause the market to tumble.