Question

(You should know what the Dow Jones Industrial Average measures.) Why is it argued that there will be a fall in the economy if there is a fall in the Stock Market? How would you feel and how would you act (in terms of purchases) if there were a sharp fall in the value of stocks that you owned? What is the evidence (that it, is it true that the fall in one causes the fall in the other)? Would this still be true if the fall were larger than the $500 billion discussed in the textbook -say some $3 trillion (as has happened some years ago)? How about the related issue: does the fall in the stock market signal a fall in the economy? How reliable is this forecasting tool?

Answer 1

In the economy, there are some indicators which economists focus on to gauge the direction of the economy. Some are known as leading indicators while some are lagging indicators. The leading indicators as the name suggests shows some signs before anything actually happen in the economy while lagging are indicates after that phenomenon happens in the economy.
The stock market index is considered as a leading economic indicator and generally, it is assumed that if there is a fall in the stock market then sentiments are adverse and economic might see a recession in the near term.

The stock market is a market for securities asset whose and ironically the market much more dependent on sentiments than actual facts in the short term. A trader would like to profit from the swings in the market either by going long or going short. However, an investor typically buys and holds for the long term. An investor should book the profit of his holding who are either at fair valuation or overvalued and he should add stocks to his portfolio which are fundamentally strong but undervalued because of a fall.

The stock market is very much game of sentiments and human psychology plays a very important role in this regard. It is true that a fall in the scrip of a sector could lead to a fall in other scrips also. It has been seen that even a fall in one sector in other country's market can also lead to panic selling in another market. However, the stock market does not have any fixed formula and reactions are not always predictable.

The big fall in the market triggers a fall in other sectors or in the other markets which is known as the contagion effect.
A big fall in 2008 in the US market triggered a wave of panic in the worldwide financial market and they witnessed heavy losses.

The stock market is considered as forward-looking and that is why it is considered as a leading indicator of the economy.
So it is generally assumed that a fall in the stock market is an indication of economic recession while a surging index is an indication of a boom in the economy. However, the stock market does not have any formula and market sentiments remain unpredictable so such indications are needed further concrete proofs and can not be accepted as a perfect.
The US stock market witnessed a big crash in 1987 and it meant a recession in the near term but such a phenomenon didn't happen and the economy actually expanded after that crash.