Last few days I am thinking about this and found few answers as well. If understanding is different from your view, bloggers can comment and correct.

Why countries economy is linked to Stock Market Index?

If stock index goes high then people are saying country is in growing mode and if it falls everyone is saying economy is going down. How the index points determines the health of economy? Even sometimes in recession index points will increase that does n’t mean country is growing (because of investor sentiment based on future anticipation it is growing high). Sometimes even in panic investors sell their shares and even that time share price will fall. My point is that if sentiment plays a role in index points then how economy status is decided based on this. Is really stock market add financial value to the economy?

Before that I will explain about Stock Market basics so that it will be helpful for the readers who wants to know basics.

Stock Market is a place where firms raises funds for their business. To be clearer stock market is always is divided into two categories

Primary market

Secondary market

Primary Market:

This is the place where companies raises funds for their business using IPO (Initial Public Offering). Actually it is the place where stock market add value to the economy of the country because based on the money collected by the company in IPO is used for business expansion. If business is getting expanded then more jobs, more export and obviously country GDP is growing. If more investments in stock market then more growth and jobs and this is the reason where developed countries have good capital market infrastructure.

What means buying share in IPO?

Investment in shares represents ownership of the company and no promised returns (means they are entitled to dividends of the company but dividend ratio is decided by the company even sometimes it can be zero).

What is dividend?

A dividend is a distribution of a portion of a company’s earnings, decided by the board of directors, to a class of its shareholders.

Is people are buying shares only for dividends?

Answer is no. Apart from dividends, more important reasons to holding stock is to get capital gains. You can see shares in the market with low dividends but high market price.

What is capital gains?

Profit from the sale of share in secondary market.

Up to this I will complete the primary market. Let’s get into secondary market where the actual game starts.

Secondary market:

Secondary market is the place where shares traded on the Stock Exchange and market participants are looking for capital gains.

Capital gains in the secondary market transaction will not add any financial value to the company.

Why still the company management worries about the price fall?

In my view there are two reasons.

1. Considerable amount of share is still in firm owner’s management so that high share prices is good for them because that is the price they can sell the shares in market.
2. Current share price of the company is the future IPO price of the company. If company needs more money in future expansion they can still issue new shares hence they always wants the current share price with high market price.

By the above you can understand secondary market trading does not add any direct benefit to the company but adds value for future growth. Then why the economy is related to the stock market index?

What drives the price of shares?

Company’s profits and future plans determines the price of the share. As of now just ignore the other contribution factors for share price i.e.) If share price goes high means company’s profit is increased. Profit increase means more business in the country and more money in the economy. This is the reason why STOCK MARKET INDEX IS RELATED TO ECONOMY of the country.

Price discovery is the biggest task in share trading. Investors has to clearly analyse the company’s profit details and pay the price for shares in secondary market. If not that leads to stock market crash like DOT COM BUBBLE (I will explain this bubble in separate post).

Apart from this taxes plays an important role. It is adding significant value to the country’s economy and it is directly added to countries income.

Let’s see how stock market adds income to the government.

Even though trading happens between two individuals in stock exchange but it adds more value to the economy in the form of tax. Let’s take one market (India) and explain this. Shares trading in India is not free from tax and there are two tax components namely

STT – Securities transaction tax

Capital gains tax

Securities Transaction Tax (‘STT’) was introduced in the Union Budget of 2004-05 by the then Finance Minister, Mr. P Chidambaram.  As the term implies, STT is a levy on the value of taxable securities purchased or sold on a recognized stock exchange in India and is collected by the broker at the time of the transaction itself. STT on different products is tabulated below

Capital gains is exempted from tax if investors holds shares for more than 12 months. If not investors has to pay 15% on the capital gains.

Around 55-60% of trading activity is done in intraday (i.e., holding a stock for less than 24 hours). Think how much of the capital gain tax will be flowing back to the government. Either BUY or SELL still government enjoys steady flow of money to their account in the form of tax.

In 2014 alone government collected 6000 crore in STT (920 Million USD) and also it is collected by broker at the time of transaction itself. Now you can understand why stock market is more important to the economy!

Every countries tax on share transaction is different from another and also we have to be careful in international share trading i.e.) have to look at tax structure of the country and then invest. I like to explain this in separate post and I will do surely.

Is stock market adds value to the economy?

Yes, stock market adds value to the economy.

This marks end of my post. Comments are more welcome!