You always hear the connection between recessions and stock markets. I understand a recession would trigger the stock market to plunge. But I don’t understand why and I also don’t understand the timeline of events of a recession and what’s happening with the U.S. economy overall during a recession.
In: Economics
From wikipedia: “In economics, a recession is a business cycle contraction that occurs when there is a general decline in economic activity. Recessions generally occur when there is a widespread drop in spending.”
When consumers are spending less, businesses take in less revenue which in turn means lower profits or possibly a loss for that business. Stock markets are the trading of tiny pieces of company ownership, so when the company you own a piece of is doing poorly, you want to sell it and by one that is doing well. In order to sell, you need to set a price better (aka lower) than everyone else, which leads to a stock’s price going down when lots of people think that same way. When there’s a recession and a GENERAL decline though, lots of people will be selling their stocks and few stocks will be a good investment since all businesses are doing poorly. This leads people to pull their money out of the stock market, reducing the amount of economic activity going on, reducing business’s revenue, and the cycle continues to feed itself.
Average Joe who isn’t invested in the stock market beyond a 401k won’t see much direct impact on his day-to-day until businesses need to raise prices to counter the loss of revenue. Then he may try to spend less on his hobbies, avoid fast food, and try to save money by not going on expensive trips. That’s also a reduction of economic activity though! That also feeds a recession cycle.
There’s also the risk that the company Average Joe works for will have a bad enough time in the recession that they need to cut costs in labor, and Average Joe is laid off! Now he really won’t have much extra cash to contribute to the economy.
As for what starts a recession, it can be unclear and hard to explain. The 2008 financial crisis was sparked by a downturn in US housing costs that wasn’t anticipated after a long period of sustained growth which cascaded into the global financial sector. COVID had a similar impact in 2020 (hard to contribute to economic activity when stay-at-home orders were active) and it could be argued we are still in the middle of the recovery from/reaction to that sudden spike in unemployment and drop in oil prices.
There’s a lot of reasons. Despite claims to the contrary, the market is tightly correlated to the real economy. Now I said correlated, not matching. The market swings wildly and dramatically, up and down. But it’s overall movement and growth or shrinkage matches a (differently numbered) overall growth and shrinkage of the economy.
Some of this is reflective of the economy, some of it is causal. It can reflect that people are nervous and want cash to weather the upcoming storm. It can be causal in that dropping valuations change whether or not your debt is sustainable and therefore whether your business will survive, killing the salaries and spending power of both your business itself and your employees.
And then we can look at it from what recessions do to the market rather than the other way around:
Recessions are a drop in economic output. Usually they are caused by something financial, a lack of aggregate demand, which is to say incomes (personal, business, etc) are too low to finance work for all the people and factories. Obviously in this situation, businesses are worth less than before as they sell less to fewer people, and fewer people and institutions have money to put into the market.
Ack. Not helping a 5yo.
There’s so much more too it. But maybe I can whittle it down to what is *often* the case:
A lack of money relative to the size of the economy means the markets become cheaper as there’s less to invest, and the businesses are selling less so are worth less. And with the businesses worth less, they can’t borrow money as cheaply so their spending goes down and it’s a cycle.
Recessions mean lower revenue and lower profits for a company as consumers pull back on spending. Lower profits, typically cause stocks to fall because P/E (price /earnings) ratio is typically one of the most looked at metric for company performance.
Take a lemonade stand. The stock market represents the money required to get it set up and running and represents the ownership of the stand. It may the kid’s allowance, the parents’ money, or some combination therein. They obviously set it up hoping the kid will turn a profit
The economy is all the ongoing spending and income. It measures the costs of the lemons, sugar, water, the implicit cost of the time of the kid running it, and the money collected from customers.
In a recession, spending drops all around. Fewer customers buy the lemonade, so the kid buys fewer lemons and sugar packets. It can create a vicious cycle if the lemon groves and sugar farms/processors cut back on operations in response to fewer sales on their end, leading to their employees having less money, meaning they may buy even fewer cups of lemonade, and so on and so forth until the only spending that’s left is what’s necessary to survive, potentially meaning the lemonade stand has 0 customers.
The “value” of the lemonade stand similarly drops. If it was making $20/day pre-recession and is now only making $15/day, ownership in that stand is less valuable, all else being equal. If the next door neighbor wanted to buy out the stand and take it over herself, she would pay less than she would have pre-recession, because it’s making $5 less per day and presumably the kid and/or the parents would be willing to accept less.
The “powers that be” get upset when Dems are in power so they do this to cause fear and anger so their puppets on the right can have a better shot of gaining power in elections.
Recessions often lead to stock market declines because economic downturns can reduce corporate profits and consumer spending. Investors typically react to these predictions, which can drive market fluctuations.
Recessions are when people aren’t making things because they can’t find a job or the right job for their skills. The stock market is basically a guess as to how much value people’s jobs will bring in the future. So when you have a lot of people that can’t find jobs and it happens really fast you will get a dip in the stock market.
Since the stock market is a guess though people could be working the exact same amount but if investors thought there was going to be more production (profits) and there aren’t then that can also cause the market to go down but it’s not connected to the actual work people are doing.
The stock market tells you how much large corporations are worth. In theory, corporations are worth a lot more money when they’re projected to make a lot of money. So if the stock market goes down, that’s a sign that people are anticipating corporations to not make as much money.
A “recession” is just a term for an economic downtown, traditionally associated with a decline in GDP. The Gross Domestic Product just refers to how much money is moving throughout the economy. People buying and selling things, making deals, money changing hands, etc.
So you can see how stock prices and GDP go hand in hand, even if they’re measuring different things. Generally speaking, if companies are making a lot of profit it’s because they’re doing a lot of business. If everyone’s doing a lot of business, then the GDP is high.
That’s the connection.
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