The upcoming crisis in the stock market easily underscores the possibility of an economic recession, and the main reason is that stocks are shares in the ownership of companies. Thus, the stock market reflects investors’ confidence in the future profits of all listed companies. Corporate profits depend on the health of the U.S. economy, which makes the stock market sometimes a leading indicator of the U.S. economy as a whole.
Impact of Crises in the Stock Market
Crises in the stock market indicate a collective loss of confidence in the economy, and when this confidence is not restored, it leads to a recession. The crisis also scares consumers from purchasing. This is a significant blow to the economy since consumer spending is the largest component (70%) of gross domestic product (GDP). The crisis also means reduced funding for new companies, as selling shares provides companies with the needed funds for growth. Finally, a crisis in the U.S. stock market slows global economic growth. First, it will cause a decline in other stock indicators, although the recession may not occur immediately after the crisis.
When the Crisis Does Not Lead to Recession
One way to avoid a recession after a crisis is when the Federal Reserve is able to restore confidence in the market. A good example is the stock market crisis in 1987, also known as “Black Monday.” On October 19, the Dow Jones Index dropped by 22.61%. It was the largest one-day percentage drop in stock market history. Panic erupted due to the impact of anti-takeover legislation passing through Congress, which would eliminate the tax deduction for loans used to finance corporate takeovers. Automated trading programs for stocks made the selling worse.
When Will the Next Stock Market Crisis Happen?
The next serious crisis is likely to occur after a period of excessive euphoria. This is when investors are so confident that stock prices will continue to rise that they lose sight of the underlying values. This type of crisis occurs only during the later expansion phase of the business cycle, when the economy has been operating at full capacity for a period of time, possibly years, and there is a disconnect between the real economy and the financial markets that represent it. When this happens, there aren’t many undiscovered investment opportunities, or rather, more accurately, there aren’t enough innovative ideas to discover those investment opportunities. As a result, investors try to outperform the market, searching for any overlooked profit and spending more money on low-return investments. Without strong fundamentals, they follow each other into anything that is rising, creating an asset bubble. When the bubble bursts, the stock market collapses. If it collapses enough, it can lead to a recession.
Examples of Stock Market Crises
You can learn when stock market crises have caused recessions by studying the history of recessions.
2008: The Great Recession
On September 15, 2008, the Dow fell by 500 points – the worst drop since the bottom of the recession in 2001. U.S. Treasury Secretary Henry Paulson did not bail out Lehman Brothers, leading to a crisis of confidence in the markets. Financial companies knew they would have to absorb the losses incurred from the subprime mortgage crisis. As the value of these financial companies’ stocks declined, they realized they would have difficulty raising new capital to cover their losses and make new loans. In this way, this stock market decline threatened to put these banks in a bind if they did not have enough reserves to cover the drop. This alone could lead to a real recession. On October 5, 2008, the Dow fell from over 10,000 to below 8,500, a drop of 15% in one week. It indicated a sudden and severe loss of confidence in the market and the underlying economy. It also led to the Great Recession of 2008.
1929:
From Recession to Depression
The worst example so far is the stock market crash of 1929, which lasted over four trading days. It began on Black Thursday (October 24), continued until Black Monday (October 28), and extended to Black Tuesday (October 29). During those four days, the stock market lost all the gains it had made throughout the year. The panic selling was not the only reason for the depression. The timeline of the depression shows that the recession had already begun in August, but the crisis destroyed confidence in business investments. Banks used depositor funds to invest in Wall Street. People who hadn’t bought a single share lost their life savings. When people learned about this, they raced to withdraw their deposits, but for most, it was too late. Banks closed over the weekend, and many of them never reopened. The economy plunged into a depression that lasted for 10 years. The stock market did not fully recover until 1954.
2001: The Dot-Com Bubble Burst
The recession in 2001 was largely the result of the millennium panic. The tech rush of 2000 began when tech experts incorrectly predicted that computer software would not be able to distinguish between the years 1900 and 2000. This led to an unnatural increase in demand for millennium-compatible hardware and software, and thus an overinvestment in tech companies. By the year 2000, most companies had purchased what they needed. Sales plummeted, and the dot-com bubble began to burst. Many high-tech companies declared bankruptcy. The attacks on September 11, 2001, exacerbated the stock market crisis in the tech sector. High-interest rates from the U.S. Federal Reserve also worsened the U.S. economy, so in
Source: https://www.thebalancemoney.com/could-a-stock-market-crash-cause-a-recession-3306175
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