Does the stock market reflect or influence the U.S. economy?
"This time it's different," Time , January 8, 2001
In the past, a relatively small segment of wealthy Americans owned stocks for the purpose of long-term investments. Nowadays, however, 49% of American households hold stocks either directly or indirectly through mutual funds or retirement accounts. Some people trade stocks often for short-term profits. Thus, stocks became an important source of liquid wealth for average households. For example, when the stock market peaked in 1999, the household wealth from stocks amounted to $5.5 trillion. Out of this additional wealth, $275 billion was spent for consumption (i.e., marginal propensity to consume out of stock wealth is .05), and this additional purchasing power significantly influenced the U.S. economy.
However, the stock market fluctuates widely over the years, especially recently. Of the many reasons for this fluctuation, two phenomena stand out as the main culprits.
First, due to the revolution in electronic information, the average American households have easy and immediate accesses to the stock market. This widespread information encourages a bandwagon effect over stocks. When the stock market goes up, everyone wants to be on the wagon and thus bids up the price of the stock to an almost irrational level (i.e., "irrational exuberance"). Similarly, when the market goes down, everyone rushes into liquidating their stock holdings, thus multiplying the slide of the market.
Second, in the past when the world was segmented and each part enjoyed a certain economic independence, the economic predicament of one part of the world did not directly affect the economy of the rest of the world. Today, through the availability of instantaneous communication vehicles, the world stock market has become totally integrated. For example, 66% of world stock funds have been invested in U.S. stocks, and therefore, any significant changes in the U.S. stocks directly and immediately affect the world stock markets, which, in turn, strongly influences the U.S. stocks themselves.
Within the last few years, the values of some of the stocks, especially in high tech areas, declined to less than 50% of their peak values. Americans had to rearrange their consumption patterns to compensate for the significant decline in stock wealth. A loss of wealth is always felt much more acutely than a gain. The gain in wealth may simply be left in savings for future use, yet its loss must be immediately covered up to avoid too serious a repercussion on retirement or on children's college education. As a consequence, some of the current income normally earmarked for current consumption now had to be transferred to savings to make up the loss of stock wealth. The impact of such major reduction in consumption was immediately felt in the economy. For example, the once venerable American retail icon, 128-year-old Montgomery Ward closed its 250 stores with 37,000 employees. Giant steel company LTV also filed for a bankruptcy.
Therefore, the stock market, instead of being a harbinger for the future of the economy, now directly influences the current economy.