What Would Happen to the Economy if the Stock Market Were to Crash?

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The U.S Stock Market has endured many ups and downs over the years- are we headed toward another crash? Image courtesy of E. Robert Fernholz

The U.S Stock Market has endured many ups and downs over the years- are we headed toward another crash? Image courtesy of E. Robert Fernholz

The numbers are both exhilarating and terrifying – all at the same time.

The Dow Jones Industrial Average has risen 19.8% so far this year, closing at 16,072.54 on November 25, 2013. The benchmark index is up 29.7% since January 1, 2012, 37.2% since 2011 and has climbed a dizzying 83.1% since the depths of the Great Recession. By comparison, GDP growth has averaged  a modest 4% over the past three years, with the inflation rate hovering around 2%.

Sound familiar? Recall the 1997-2000 dot-com economy and the housing market run-up during the early-to-mid  2000′s and the notable lack of fundamental economic factors driving those periods, and the risk becomes all too apparent. By most measures, speculation and artificial means are driving the stock market – these drivers cannot sustain themselves. If this is the case, the risk of an impending crash is high.

Investor Carl Icahn is admittedly “very cautious” about stocks right now, telling Reuters:

“I am very cautious on equities today. This market could easily have a big drop. Very simplistically put, a lot of the earnings are a mirage. They are not coming because the companies are well run but because of low interest rates.”

When a correction finally occurs, it may well be one of substantial proportions. What would happen to the economy if the stock market were to crash?

A Stock Market Crash Could Cause Businesses to Cut Back

When businesses require operating capital or capital for specific purposes, they generally acquire it in one of three ways:

  • Equity (typically by selling stock)
  • Debt
  • A mixture of equity and debt

Were the stock market to fall precipitously, selling stock would naturally be much more difficult, as investors would be looking to move out of equities and thus be less inclined to buy them. Furthermore, if interest rates were to go up, borrowing costs could become prohibitive. If a company were unable to raise enough capital to fuel growth or for capital investment purposes, it could  delay major projects or possibly even cut back on general operations. Doing so could entail hiring freezes, reduced payroll or even layoffs — strategies that would directly impact consumer spending, as personal income growth would slow and the unemployment rate would rise.

During the post dot-com era, unemployment increased from just under 4% to over 6% in the span of two years.

A Crash Would Deal a Blow to Consumer Confidence

In the months following the end of the dot-com era, the exploded bubble triggered a huge decline in consumer confidence. After reaching 145 in May, 2000, the Conference Board’s Consumer Confidence Index fell 17 points over the rest of the year, and 33 more points in 2001, further depressed by the events of 9/11. Investopedia defines the Consumer Confidence Index as follows:

The idea that if the consumers are optimistic, they will tend to purchase more goods and services. This increase in spending will inevitably stimulate the whole economy.

The opposite is true as well. If consumers have less discretionary income and are thus pessimistic about the present and near-term future, they will purchase fewer goods and services. This tends to cause dramatically slower growth and lowers the overall economic outlook. Likewise, if an investor has a significant amount of their assets in stocks, they may perceive themselves as poorer upon seeing the decline in their portfolios and feel the need to cut back as a result.

The resulting combination of real and psychological factors on spending patterns could have a painful impact on the overall economy.

The Economy Would Probably Experience Another Recession

The dot-com era crash led to the recession of 2000-01, and the popped housing bubble triggered the Great Recession. Were the stock market to crash once more, it would be reasonable to conclude that the already-frail U.S. economy would fall into yet another recession, one which by historical standards may already be overdue.

As we’ve seen from previous downturns, the impact upon the average American from a recession is all-too-familiar. Unemployment increases, wages remain stagnant, housing stalls, wealth diminishes and in certain cases — like the stagflation of the 1970′s —  the economy stalls at the same time as inflation and interest rates soar. Many economists believe that a period of abnormally high inflation and rising interest rates is overdue, held down artificially by the bond-buying program currently being deployed by the Federal Reserve.

Stock Market Crash: Know When to Say When

At some point, the stock market will experience a correction, if not crash altogether. We don’t know whether the correction will be of the normal, healthy kind or an all-out crash. The average investor would be wise to diversify their portfolio sufficiently so that although they may not be cresting the wave of abnormally high stock market returns completely, they can weather an eventual downturn with fewer losses.

As American writer Irene Peter once said, “Anyone who thinks there’s safety in numbers hasn’t looked at the stock market pages.”

Resources

Google Finance. Dow Jones Industrial Average 2 Minute(2013). Accessed on November 26, 2013.

Herbst-Bayless, Svea and Ablan, Jennifer. Icahn warns stock market could face ‘big drop.’ (2013). Reuters. Accessed on November 26, 2013.

Multpl. US Growth Rate by Year(2013). Accessed on November 26, 2013.

Bureau of Labor Statistics. Unemployment Rate(2013). Accessed on November 26, 2013.

Investopedia. Consumer Confidence Index – CCI(2013). Accessed on November 26, 2013.

McArdle, Megan. Did Demographics Cause 1970s Stagflation? (2013). Bloomberg. Accessed on November 26, 2013.

BrainyQuote. Stock Market Quotes(2013). Accessed on November 26, 2013.

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© Copyright 2013 Walter McLaughlin, All rights Reserved. Written For: Decoded Science
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Comments

  1. John Jaksich says:

    I don’t always see the salient points discussed so readily. Thanks for breaking it down. All too often when I listen to pundits speak of the great recession, they are far too apt to blame their opponents.

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