What Is Wall Street? Its Role in the Economy

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Wall Street is an eight-block street in Lower Manhattan, New York City. It is also shorthand for the entire U.S. securities and investment industry: the banks, brokers, exchanges, funds and traders that raise capital for companies and governments, price and trade financial assets, and manage money for investors. When a headline says “Wall Street rallied” or “Wall Street expects a rate cut,” it means the industry and the markets it runs, not the street.

The two meanings overlap only partly. The New York Stock Exchange still sits at the corner of Wall and Broad Streets, but many firms counted as “Wall Street” are headquartered in Midtown Manhattan, Chicago, Boston, San Francisco or elsewhere. In financial usage, “Wall Street” or simply “the Street” describes a function, not an address.

What Is Wall Street?

The physical Wall Street runs less than a mile across the southern tip of Manhattan, from Broadway to the East River. The surrounding Financial District holds the NYSE building, Federal Hall and the offices of many banks and law firms.

As a figure of speech, Wall Street originally meant the small group of large independent brokerage and investment banking firms that dominated American finance. That meaning faded after the 1999 Gramm-Leach-Bliley Act removed most of the Depression-era separation between commercial and investment banking. It faded further in 2008, when the last major independent investment banks failed, were absorbed by commercial banks or converted into bank holding companies. Today the term covers a broad set of participants:

• Investment banks, which underwrite stock and bond offerings and advise on mergers and acquisitions
• Commercial banks with trading and capital markets divisions
• Broker-dealers, which execute trades for clients and trade on their own account
• Asset managers, including mutual fund companies, pension managers and hedge funds
• Insurance companies, which invest large pools of premiums
• Exchanges and market infrastructure, such as the NYSE, Nasdaq, clearinghouses and custodians
• Currency, commodity and derivatives traders

Where the name comes from

The name comes from a wooden wall that Dutch settlers of New Amsterdam built along the northern edge of their colony in the 17th century. In 1792, a group of brokers signed the Buttonwood Agreement, which set common commission rules for trading securities and is regarded as the origin of the New York Stock Exchange. The exchange is nicknamed the Big Board, after the large boards once used to display stock prices.

How Wall Street Works

Wall Street’s work falls into a few core functions. Each connects people who have money with businesses or governments that need it.

Raising capital. When a company wants to sell shares in an initial public offering or issue bonds, investment banks underwrite the deal. They help set the price, find buyers among institutional investors and earn an underwriting fee. Governments and municipalities borrow through the same bond market machinery.

Trading and market making. After securities are issued, they trade on exchanges such as the NYSE and Nasdaq, on over-the-counter markets and through alternative trading systems. Broker-dealers execute orders for clients and earn commissions or the bid-ask spread. Market makers stand ready to buy and sell so investors can trade quickly. Trades settle through clearing and depository institutions, and most U.S. stock trades now settle one business day after the trade date (T+1).

Advising. Banks advise companies on mergers, acquisitions, restructurings and defensive strategies and charge advisory fees.

Managing money. Asset managers invest on behalf of individuals, pension funds, endowments and insurers. They typically earn a management fee based on assets, and some funds also take a share of profits.

Research. Analysts at sell-side firms (the banks and brokers that sell securities and trading services) study companies and industries. They publish forecasts and recommendations used by buy-side clients such as pension and mutual funds.

Some firms also profit by identifying companies likely to rise in value and investing their own capital, though post-2008 rules such as the Volcker Rule in the Dodd-Frank Act restricted proprietary trading at banks that take insured deposits.

Street estimates and why expectations drive prices

Financial asset prices are based on current information and the assumptions investors make about the future. Because the current price already reflects what investors expect, prices tend to move on surprises, not on news as such.

For companies, the reference point is the Street estimate: the average of analysts’ forecasts for a company’s quarterly revenue and earnings per share (EPS). Most medium and large public companies are covered by several analysts. Each builds a financial model of the business and publishes quarterly and annual projections. When the company reports, results are compared with the consensus:

• Meet: results come in at or near the Street estimate. The stock price often reacts modestly, since the outcome was largely priced in.
• Beat: results exceed the estimate. The stock often rises, particularly if management also raises its outlook.
• Miss: results fall short. The stock may drop sharply, even if earnings grew compared with last year.

A company can report record profit and still fall if the record was smaller than expected. Forward guidance can matter as much as the quarter itself, because investors value the stock on future earnings, often summarized through measures such as the P/E ratio.

Economic data works the same way. Every major release, such as the monthly jobs report, inflation figures or GDP, has a consensus forecast. A release in line with consensus usually has a limited effect. A large deviation in either direction can move broad indexes such as the S&P 500 and the Dow Jones Industrial Average, which commentators use as the scoreboard for “Wall Street’s” reaction.

Example of Wall Street at Work

The numbers in these hypothetical cases are illustrations, not real data.

Hypothetical example 1: an earnings beat. Analysts covering a retailer forecast quarterly EPS of $1.50, so the Street estimate is $1.50. The company reports EPS of $1.62.

Beat size = (Actual EPS − Estimate) ÷ Estimate = ($1.62 − $1.50) ÷ $1.50 = 0.08, or 8%

An 8% beat is a clear surprise, and the stock may rise if management keeps its full-year outlook unchanged. If management cuts its outlook despite the beat, the stock can still fall.

Hypothetical example 2: a weak jobs report. The economy appears to be growing steadily, and economists expect the monthly payroll report to show 250,000 new jobs. The report shows 100,000.

A miss of that size can trigger a chain reaction:

1. Economists at Wall Street firms reconsider their assumptions about growth.
2. Some firms lower their GDP forecasts, and their equity strategists cut year-end targets for the S&P 500.
3. Institutional clients receiving the revised outlooks decide to reduce some stock holdings.
4. Selling from many large investors at once pushes major indexes lower by the close.

Why Is Wall Street Important?

The United States is the world’s largest economy, and its stock market is the largest in the world relative to that economy. The NYSE leads the world by total market capitalization of listed companies, and Nasdaq ranks second. Decisions made in U.S. markets affect asset prices, borrowing costs and capital flows well beyond U.S. borders.

Within the U.S. economy, Wall Street’s influence runs through three main channels.

The wealth effect. When stock portfolios rise in value, households feel richer and may spend more on big-ticket items such as cars, renovations and travel. Some economists argue the effect is stronger from rising home prices than from rising stock prices, but the general direction is widely accepted.

Confidence. Bull markets tend to coincide with periods when consumers and businesses feel optimistic about the future. Consumer spending makes up roughly 70% of U.S. GDP, so shifts in household confidence that show up in spending have a large effect on overall output.

Business investment. When stock prices are high, companies can raise capital by selling shares on favorable terms. They can then use the money to build facilities, buy equipment, acquire competitors and hire. A company’s share price also affects its ability to use stock as currency in acquisitions and as compensation for employees.

How Wall Street affects ordinary Americans

Most people are tied to Wall Street through their savings. Retirement accounts such as 401(k)s and IRAs hold stocks and bonds, usually through mutual funds and ETFs run by Wall Street asset managers. When markets fall, those balances fall too, and a person close to retirement may have to delay plans or reduce withdrawals. Pension funds also depend on investment returns to meet their obligations.

Wall Street also shapes borrowing costs. Mortgage rates track yields in the bond market, where mortgage loans are packaged and sold to investors. Corporate borrowing costs affect whether employers expand or cut back, which reaches workers through hiring and wages.

Wall Street as an early indicator

Because prices reflect expectations, the market often moves before the economy does. A substantial stock market decline is often treated as a warning of recession. Historical examples show recoveries starting on Wall Street as well. A major rally in March 2003 preceded the global expansion that ran to 2007. In March 2009, during the deepest recession since the 1930s, a powerful Wall Street rally marked the start of the climb out.

Some global downturns have also started in the United States. The 2000 to 2002 slump followed the collapse of the technology stock bubble, and the 2008 to 2009 crisis grew out of the U.S. housing market and the mortgage-backed securities built on it.

Limitations of Wall Street as an Economic Signal

The market’s record as a forecaster is mixed. The 1929 crash was followed by the Great Depression, but the October 1987 crash, when the Dow fell about 22% in a single day, was not followed by a recession. Economist Paul Samuelson summed up the problem with his remark that the stock market had predicted nine of the last five recessions.

Several features make Wall Street an imperfect gauge of the broader economy:

• Index composition. Major indexes are weighted toward large companies, many of which earn a significant share of revenue abroad. A rising index can reflect strong results at a handful of giant firms while smaller domestic businesses struggle.
• Ownership is concentrated. Stock holdings are spread unevenly across households, so market gains and losses do not reach all Americans equally.
• Prices discount the future. Markets can rise during a recession if investors expect recovery, and fall during an expansion if they expect it to end. Stock prices and current conditions often point in different directions.
• Interest rates matter. Changes in rates and Federal Reserve policy can move stock valuations for reasons unrelated to company performance.

Criticisms of Wall Street

• Fears that markets are rigged. Most trading happens under rules enforced by the Securities and Exchange Commission and other regulators. Still, high-profile cases have fed the view that insiders have an edge. Galleon Group co-founder Raj Rajaratnam was convicted of insider trading in 2011, and people tied to SAC Capital Advisors were convicted in later years.
• Lopsided risk-taking. Traders and executives can earn large bonuses when leveraged bets pay off but do not personally bear the full cost when they fail. This pattern is widely seen as a contributor to the 2008 collapse in mortgage-backed securities.
• Dangerous derivatives. In his 2002 letter to Berkshire Hathaway shareholders, Warren Buffett called derivatives “financial weapons of mass destruction,” a warning many saw confirmed by the housing collapse.
• “Too big to fail.” Rescuing giant firms considered too important to collapse can require taxpayer funds or government guarantees, which critics say rewards the risk-taking that caused the trouble. Problems that begin in finance can spread to the whole economy, as the Great Recession showed.
• Disconnect from Main Street. Some view Wall Street as a layer of highly paid intermediaries that captures value instead of creating it for the real economy.
• Pay and public anger. Very large compensation packages drew sharp criticism after the 2008 crisis. The Occupy Wall Street movement, which began in 2011 near the Financial District, protested the power of major banks and corporations over politics and their role in the crash.

Regulators responded to the crisis with the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, which added stress testing for large banks, new rules for derivatives trading and the Consumer Financial Protection Bureau. Debate continues over whether those rules went too far or not far enough.

Wall Street vs. Related Terms

Wall Street vs. Main Street. Main Street stands for the everyday economy of small businesses, workers and consumers. Wall Street stands for the financial sector that funds, trades and invests in that economy. The contrast usually comes up when the two seem to be moving apart, such as stocks rising while unemployment is high.

Wall Street vs. the stock market. The stock market is the system of exchanges and trading venues where shares change hands. Wall Street is broader: it includes bond markets, currency and commodity trading, investment banking, asset management and research. “Wall Street rose today” is media shorthand for “U.S. stock indexes rose today.”

Wall Street vs. the NYSE. The NYSE is a single stock exchange, now owned by Intercontinental Exchange. It is the most famous institution on Wall Street, but Wall Street also includes Nasdaq, other exchanges and thousands of firms.

Wall Street vs. the Financial District. The Financial District is a Manhattan neighborhood. Wall Street is one street within it, and in the figurative sense, an industry that extends far beyond it.

Is Wall Street a sector? In casual use, yes: it is a common name for the financial services industry. In formal sector classifications used by index providers, financial firms are grouped under a “financials” sector, and “Wall Street” is not an official category.

FAQs

The Bottom Line

Wall Street matters to anyone with a 401(k), IRA, pension or mortgage, because its prices shape retirement balances and borrowing costs. Markets react to news compared with expectations, so a strong report can still send stocks lower if it falls short of the consensus. Stock indexes often move ahead of the economy, but their record as a recession signal is mixed, so a market decline works as a warning sign with a spotty track record.