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Could a Stock Market Crash Cause a Recession?

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Floor of NYSE

Floor of NYSE (Credit: Spencer Platt/Getty Images)

Question: Could a Stock Market Crash Cause a Recession?

Answer: Since stocks are a piece of ownership in a company, the stock market reflects investors' confidence in the future earnings of all these companies. Since corporate earnings are dependent on the health of the U.S. economy, the stock market is also an indicator for the U.S. economy itself.

What is a stock market crash?  A great example is what happened the week beginning October 5 2008, when the Dow fell from over 10,000 to below 8,500, a 15% decline in one week. It signals a sudden loss of confidence in both the market and the underlying economy.

If confidence is not restored, it could contribute further to recession, as happened in 2000. That’s because declining stock values means less wealth for consumers, whose purchases drive 70% of the economy. (See "What Are the Components of GDP?"). It also means less financing for new businesses, since the sale of stocks is one way that companies can get the funds needed to grow. (See ”How Do Stocks and Stock Investing Affect the U.S. Economy?")

Last, but certainly not least, a declining stock market could eventually lead to a slowdown in the global economy. That is because the U.S. economy provides 20% of the world's output. (See "The Power of the U.S. Economy")

On the other hand, if it is not sustained, it could only serve as a warning sign of a loss of investor confidence. For example, in Q1 2007 the Dow fell over 600 points in a little over a week. However, it recovered during the year, and went on to a high of 14,000 in October. Although the crash did not cause a recession itself, it did signal that one was coming.

The only way to tell if a stock market crash is helping to cause a recession is to closely follow economic indicators for six months to see if it's signaling an approaching economic downturn.

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