Frequently, when an economy is close to recession, economists will warn that some unspecified and perhaps unpredictable "external shock" will push the teetering economy into recession. As we ponder the prospects for the economy, it occurs to us that -- leaving aside the possibility of some external shock intensifying the weakening of our economy -- it may be that what we would call an "internal shock" could have the same effect. What "internal shock" are we thinking about? Well, the possibility of a further decline in stock prices, interrupted only temporarily by short-lived rallies. Such an unfolding of events -- currently, seemingly, well on the way to realization -- could give the economy a strong downhill shove.
There are several reasons for this, we believe.
--In the first place, equities constitute an important component of the total net worth of Americans. Two groups are especially impacted by the rise or fall of the market: the highest income/wealth groups, and the generality of retirement savers in their 401K plans and their IRAs. A substantial decline in the level of equity prices would reduce the financial reserves of the rich, and would impact their spending behavior. Such a wealth-erosion would, after all, COMPOUND significantly the net worth erosion they have already sustained in consequence of the real estate bear market, where their property investments have deflated significantly. As for the ordinary 401Kers, whose primary asset has already diminished sharply in price (their house), a significant drop in the equity component would amplify the blow. The "wealth effect," as is well known, spurs consumer spending. A "poverty effect" would have the opposite effect. This is particularly significant when the consumer is reeling in consequence of the well-known factors: decline in home equity against which borrowings can be made; the surge in energy prices, which eats into discretionary income and spending; and, more recently, a rise in unemployment, which places a damper on wages and salaries and which increases the overall angst of the typical American consumer.
--A second important consequence of the "internal shock" of a serious market correction would be its impact on the spirits and thinking of top corporate executives. These folks are the prime decision-makers for things like business investment and spending, hiring, salaries, etc. When they see their stock portfolios sink in value, and the stock of their employer drop, it depresses their spirit and makes them more pessimistic about their own businesses. This in turn leads to a curtailment of investment, spending, and expansion, with negative reverberations through the economy, reinforcing the negative ripple effect of the bear market in real estate (now spreading, as we forecast months ago, to commercial real estate).
Of course, the market may rally; the recent low may turn out to be the trough and there may be no significant negative impact on corporate spending.
We were merely ruminating.
