The Stock Market as an Economic Indicator

The stock market is another leading economic indicator. The stock market doesn’t equal the real economy—and is generally a bad barometer of how the economy is performing for most people—but it’s been crashing because expectations about real economic activity and profits are crashing. You can loosely think of the stock market as pricing the expected future flow of discounted after-tax corporate profits; when the economy tanks, or investors expect the economy to tank, expected profits tank too.

NYT (3/18/20): Do Recessions Always Follow Major Stock Market Downturns? Usually

As this NYT Upshot piece explains, recessions are usually preceded by significant declines in the stock market. That doesn’t mean that stock market crashes cause recessions, but they are correlated with future downturns in GDP, and thus have predictive power for forecasting recessions.

Chistina Romer has a classic paper, The Great Crash and the Onset of the Great Depression (1990, QJE), on the role higher stock market volatility—as opposed to wealth effects from a falling stock market—as a propagating force in depressing demand during the Great Depression. The gist: Higher volatility generates uncertainty about income or collateral value, inducing consumers and business to forgo consumption or investment until that uncertainty is resolved.

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