Will the Next Stock Market Crash Cause a Recession?
The next stock market crash can easily kick-start a recession. That's because stocks are shares of ownership in a corporation. As a result, the stock market reflects investors' confidence in the future earnings of all the companies in it. Corporate earnings are dependent on the health of the U.S. economy. That maakes the stock market a leading economic 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. Declining stock values mean less wealth for investors. A crash also frightens consumers in buying less. Consumer spending is the largest component of gross domestic product, adding almost 70$ to the economy.
A crash also means less financing for new businesses. The sale of stocks provide companies the funds they need to grow. It's one of the ways that stocks affect the U.S. economy.
Last, but certainly not least, a declining U.S stock market slows global economic growth. First, it will cause the other stock indexes to decline. The power of the U.S. economy contributes 20% to global production.
The recession may not follow right a crash right away. The Dow closing history provides many examples. In the first quarter of 2007 the Dow Jones industrial average fell more than 600 points in a week. But it recovered during the year and rose to a high of 14,000 in October. Although the crash did not cause a recession itself, it did signal that one was coming.
A stock market crash doesn't always end in recession. If the Federal Reserve 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, the Dow dropped 22.61%. It was the largest one-day percentage drop in stock market history. Investors had panicked over the impact of anti-takeover legislation moving through Congress. The bill would have eliminated the tax deduction for loans used to finance corporate takeovers.
Computerized stock trading programs made the sell-off worse. The Fed immediately started pumping money into banks. As a result, the market stabilized. The Fed's action avoided a recession.
When Will the Next Stock Market Crash Occur?
The next serious crash will probably occur after a bout of irrational exuberance. It occurs when investors are so confident that stock prices will keep going up they lose sight of underlying values.
It only happens during the later expansion phase of the business cycle. That's when the economy has been running at full capacity for a while, maybe even years. There aren't many undiscovered opportunities. If investors strictly followed the fundamentals, they would reject these poor investments and remain in cash.
Instead, they try to outperform the market. They search for any overlooked profit. They sink more money into investments with poor returns. Without solid fundamentals, investors follow each other into whatever is rising. They create an asset bubble. When the bubble bursts, the stock market crashes. If it crashes enough, it can create a recession.
You can learn about when stock market crashes caused recessions by studying the history of recessions.
On September 15, 2008, the Dow 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 had sustained from the subprime mortgage crisis.
As the value of these financial companies' stocks fell, they knew they would have a hard time raising new capital to cover their losses and make new loans. In this way, the stock market decline threatened to put these banks out of business if they didn't have sufficient reserves to cover the downturn. This, in and of itself, could have put the economy into a bona fide recession.
Another example 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. It also triggered the Great Recession of 2008.
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 24) and lasted until Black Tuesday (October 29). 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 by itself. The Timeline of the Great Depression shows 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.
How It Affects You
What should you do to protect yourself? First off, don't panic. The bottom of a bear market has huge swings and volatility. That turns into panic and doom-and-gloom predictions from economists. A recession does not a depression make. There is always economic growth in other parts of the world. The only way to tell if a stock market crash is causing a recession is to closely follow economic indicators.