Friday, October 17, 2008

Does Stock Market Crash Often Followed By A Recession (or Depression)?

Yes,

(1) Falling wealth. In most countries, people generally store their wealth in property market & stock market. With market crash, it means consumers’ wealth is wiped off & this could undermine their willingness to spend into the economy & this leads to fall in consumption. Fall in AD will cause real GDP to fall.

However the situation could be unique in UK, as most Britons store their wealth in property market. People there even view shares as speculative investment. This means when share prices go up, people do not spend more & when share prices go down, they do not cut their spending. It’s also worth to note that only small % of populations have significant savings in shares. At the moment, wealth crisis in UK wasn’t stemmed from falling stock index, but rather a series of falling house prices which has to do with high default rate of subprime mortgage loan

(2) Falling investment. In the period of falling share prices, firms may find difficulty in raising capital through the issuance of shares. Therefore this may prompt them to defer or cancel an investment project causing a fall in AD. Real GDP will decline & this causes negative economic growth

(3) Fall in confidence. This depends on how long & how severe is the crash. Most notably was the October 1929, Great Depression where share prices suffer from such a large fall & is prolonged that it causes a general decline in economic confidence & collapse of financial institutions. Consumers cut their spending & firms continue to hold back their investments, causing a large scale of unemployment & fall in economic growth. These effects were magnified by a negative multiplier effect, when things happen in a cycle

No,

(1) Market correction. In many occasions, stock market crash does not lead to recession. Those share prices are falling because they are overvalued whereas economic fundamentals remain intact. A good example will be the notorious October 1987 crash, where the market crashed by as much as 25% in a single day of trading, but didn’t cause any significant economy problem to both UK & US economy. Share prices began to recover in late 1980s & UK enjoyed a high economic growth that time (refer diagram below)


October 1987 crash in UK

October 1987 crash in US

In a nutshell, whether the economy will run into a recession due to crashing stock market depends on what causes the stock market to crash. If it is a correction, the fall will likely be short-lived & it will not harm the level of confidence.
However if prolonged, people may think otherwise & this cause them to overreact & run into panick. This further exacerbate fall in stock prices. Also it depends on economic fundamentals. Like now, many banks have problem with their balance sheet due to over-exposure to subprime lending. This causes the valuation of their stocks to be bad. Furthermore, given these banks are heavyweights in the construction of Dow Jones & FTSE index, the fall in their market capitalisation will defnitely pull down those indexes a lot

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