A Market Slide Won’t Crash

First, let’s hear from the rampaging bulls. The economy is in great shape. It is growing at an annual rate of around 3%, inflation is nil, consumer confidence is at its highest level since 1979, everyone who wants a job has one. And the outlook is for more of the same. Dow 7000, 8000, 9000, here we come.

Now for the bears. The ratio of share prices to cash flows and of market to book values are “lofty by historic standards,” while dividend yields are “the lowest ever,” says Wall Street economist Henry Kaufman. If prices are not to collapse, profits must continue to rise and the inflation genie must remain bottled up. Neither is certain. Corporate America has already cut staff levels to the bone. Consumers are so deeply in debt that they soon will holster their credit cards. Worse, inflation is about to rear its ugly head, forcing interest rates up. That will bring the rise in stock prices to a shuddering halt and lead investors to stampede for the exits.

So the stock market will continue to rise, unless it falls or moves sideways. Does it all matter to the real economy, where real people have real jobs and earn real dollars for real work? If stock prices take a tumble, will they go into free fall and take the real economy with them? After all, when shares nosedived in 1929, the market took the entire economy down with it. Can that happen again?

Yes. But it’s not likely. For one thing, any decline in stock prices is more likely to be contained now than was the case 68 years ago. After the precipitous drop in the market in 1987, the New York Stock Exchange created so-called circuit-breakers. If the Dow Jones Industrial Average falls more than 250 points from the previous day’s close, trading is halted for 30 minutes; if the decline is 400 points, trading is halted for an hour. This gives investors time for a bit of reflection as to whether they wish to join a panicky dash for the exits.

More important, Alan Greenspan proved in 1987 that the Fed can prevent a fall in prices from becoming a liquidity crisis. First, he loudly announced that the Fed stood ready to support the system with adequate liquidity, thereby reducing the panic and the magnitude of the required intervention. He kept his word: When investors decided to exchange shares for cash, Greenspan made sure the brokerage houses and the banks had enough cash to meet their requirements without forcing interest rates up to recession-inducing levels.

All of which leaves one danger to consider. The market value of corporate equities held directly by households now stands at about $4.5 trillion, excluding mutual funds. A fall in share prices equal to the 1987 drop of 22% would leave people poorer, or at least less rich, by about $1 trillion. If they decide to react to their loss of wealth by staying away from the shops and malls, the real economy might follow the paper economy into the tank.

Some economists say that every $100 decline in the stock market reduces total consumer spending by $4 over a one-year time horizon. So a 22% market plunge translates into a $40 billion reduction in consumer spending. That would slow the real economy more than a little. But if that decline is quickly reversed, as it was in 1987 when the Fed moved so effectively, this so-called wealth effect of a drop in the value of people’s assets would not play itself out.

This does not mean, of course, that an all-wise Fed can keep the stock market from falling. Nor does it mean that we will never again have a recession. We most certainly will. But it does mean that the real economic effect of any fall in the stock market is unlikely to follow the pattern that etched 1929 in the memories of all save the most callow traders.