Monday, August 13, 2007

What Happens when the stock market Falls?

What effect does a falling stock market have on the Economy?

Stock exchanges, in both the UK, US and around the world have recently witnessed significant falls in their value. For example, the London Stock exchange has fallen by 10% in the past month. For many people who don't own shares, they may ask does a falling stock market impact on the wider economy? The answer is that it depends on many factors.

1. The stock market has successfully predicted 10 of the last 2 recessions.

The stock market often falls without causing a recession. For example in 1987 the stock market crashed by 25%, but economic growth remained high. Often when a stock market fall it is merely correcting for a fundamental imbalance in the value of shares and is not a reflection of wider economic problems

2. Falls in share prices do not necessarily lead to lower spending.
Most people who buy shares see them as speculative investment. When they go up they don't start spending more; when they fall, they don't reduce spending. Basically wealth in the form of shares is a very poor guide to consumer spending; unlike the value of houses which can affect consumer spending.

3. Effect on confidence.
Falling share prices can undermine business and eventually consumer confidence. Falling stock markets reduce the scope for firms borrowing money. Therefore, they may reduce their investment spending which impacts on the economy.

4. Reason for falling share prices.

The impact of a falling stock market usually depends on why it is falling. For example, if share prices are falling because they are overvalued, this is not going to affect the wider economy. However, if falling share prices are a reflection of serious economic problems, then it is the serious economic imbalances that will cause a recession. The stock market is merely an indicator of the economic problems.

With regard to the current economic problems, a significant cause of the falling stock market is problems in the Sub prime mortgage industry. Many borrowers are defaulting on their repayments causing some big sub prime lenders to go out of business. This has affected many big banking and investment firms who have had to write off bad debt held in these mortgage companies they had invested. On its own this will not cause a recession. However, a real downturn in the US Housing market could be a trigger to causing a recession.

If house prices are falling, consumer wealth and confidence falls, this causes lower spending and lower growth. If people are defaulting on mortgage payments and having homes repossessed it means they are struggling financially. Therefore, this will contribute to falling growth. If problems in the housing market are extensive and widespread this could be a catalyst for a full blown economic recession.

Therefore, there is a link between share prices and the economy. However, often the link is merely to serve as an indicator of economic strength. Share prices are not the cause of recessions, but can sometimes be a barometer of the state of the economy.

See also: effects of Falling Stock Market on Housing Market


market forecast said...

Though not entirely true, stock prices are somewhat a determinant of economic conditions. This may be a premise on whether investments will flourish or not.

Options Trading said...

Very well said. Economists in many countries see the importance of having a healthy stock market in determining the financial strength of the nation.

Billy said...

I agree. Stock market determines the financial strength of the nation. This is the reason why London, NY and Tokyo are among the leader in financial economies because of their stocks perform well. Anyway, as an individual who joins binary options trading, it is important to know when and how to trade to ensure good benefits and revenues.