Will the Next Stock Market Crash Cause a Recession?

A man runs along Broadway June 7, 2012 near Wall Street and the New York Stock Exchange in New York City.. Photo by Robert Nickelsberg/Getty Images

The next stock market crash can easily kick-start a recession. That's because stocks are shares of ownership in a company. As a result, the stock market reflects investors' confidence in the future earnings of all these companies. Corporate earnings are dependent on the health of the U.S. economy. That means the stock market is also an indicator for the U.S. economy itself.

A crash signals a massive loss of confidence in the economy.

When confidence is not restored, it leads to a recession. That's because declining stock values means less wealth for investors. Consuer purchases drive 70% of the economy. See What Are the Components of GDP? 

It also means less financing for new businesses. The sale of stocks is one way that companies can get the funds needed to grow. See How Do Stocks and Stock Investing Affect the U.S. Economy?

Last, but certainly not least, a declining stock market could slow global economic growth. That is because the U.S. economy provides 20% of the world's output. See The Power of the U.S. Economy

The recession doesn't follow right away. For example, in Q1 2007 the Dow fell over 600 points in a little over a week. But it recovered during the year, and went on to a high of 14,000 in October. Although the crash did not cause a recession itself, it did signal that one was coming. For more, see Dow Closing History.

A stock market crash doesn't always end in recession. It also serve as a warning sign of a loss of investor confidence. If the Fed can restore confidence, it will avoid the recession.  A good example is the stock market crash of 1987, also called Black Monday. On October 19, 187, the Dow Jones Industrial Average dropped 22.61%, the largest one-day percentage drop in stock market history.

Investors panicked over the impact of anti-takeover legislation moving through Congress. It would have eliminated the tax deduction for loans used to finance corporate takeovers. Computerized stock trading programs made the sell-off worse.  The Federal Reserve immediately started pumping money into banks. As a result, the market stabilized. The Fed's action avoided a recession.

More Examples

On September 15, 2008,  the Dow Jones Industrial Average dropped 500 points, the worst drop since the bottom of the 2001 recession. U.S. Treasury Secretary Henry Paulson's refusal to bail-out Lehman Brothers threw the markets into a crisis of confidence. That's because financial companies knew they would be forced to eat the losses they sustained from the Subprime Mortgage Crisis.

As the value of these financial companies' stocks fell, they knew they would have a harder and harder time raising new capital to both cover their losses, and make new, good loans. In this way, thje stock market decline threatened to put these banks out of business if they didn't have sufficient reserves to cover this downturn.

This, in and of itself, could have put the economy into a bona-fide recession.

Another example is what happened two weeks later. On October 5, 2008, the Dow fell from over 10,000 to below 8,500, a 15% decline in one week. It signaled a sudden and extreme loss of confidence in both the market and the underlying economy.

The worst example is the stock market crash of 1929. It occurred over four trading days, from Black Monday also refers to October 28, 1929. It was the first Monday after Black Thursday (October ) to Black Tuesday. During those four days, the stock market lost all gains it had made during the entire year.

The sell-off didn't cause the Great Depression of 1929 by itself. A recession had already begun in August. But the crash destroyed confidence in business investing. That's because banks had used their depositors' money to invest on Wall Street. People who had never even bought a single stock lost their life savings. When people found out, they rushed to take out their deposits. But for most, it was too late. Banks closed over the weekend, and many never reopened. The stock market didn't fully recover until 1954. The economy sank into a ten-year depression. For more, see Timeline of the Great Depression.

How It Affects You

What should you do to protect yourself? First off, don't panic. The bottom of a bear market looks just like what we are seeing: huge swings and volatility, panic, and doom-and-gloom predictions from economists. A recession does not a depression make, and there is always economic growth in other parts of the world, such as China, India and Southeast Asia, Brazil, Chile and some Central European countries. The only way to tell if a stock market crash is helping to cause a recession is to closely follow economic indicators for six months to see if it's signaling an approaching economic downturn. 

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