The relationship between stock prices and the broader economy is reciprocal. Not only do the health and expected future growth rate of the economy influence stock prices, but stock prices also affect the economy. Falling stock prices have far-reaching consequences on consumption, unemployment and investment by individuals and corporations.
When stock prices decline, a broad segment of the public gets poorer. Retirees who depend on regular income from a stock portfolio the meet their daily needs see an immediate decline in their disposable income. Even people who were not intending to sell the stocks in long-term portfolios for many years worry whether they will have enough savings for their kids' college educations or to live comfortably after they quit working. These people start to live more frugally, and consumption of many products -- especially luxury goods -- declines. Corporations selling such things as jewelry, expensive cars and cruise line vacations and other companies making nonessential items take the greatest hit.
As people consume fewer nonessential products and services and flock to bargain-priced essentials, companies make less money or start to report losses. In turn, corporations cannot afford to employ as many people and layoffs start. For firms to actually begin cutting payrolls, stocks have to decline more than a few percentage points, and stock prices have to stay low. Layoffs are costly due to severance packages that need to be paid, and they also devastate the morale of employees left behind. Companies will only lay off workers if their managers think stock prices -- and the consequent demand for their products -- will remain low for an extended period.
As consumers get poorer, they start to save more. When surviving workers realize their stock portfolios will not earn the college or retirement funds they expected, they try to make up for the shortfall by saving more of their disposable income. This is especially difficult if they also have to accept pay cuts from companies whose revenues are shrinking. When workers try to save more of this smaller paycheck, the amount they can afford to spend declines dramatically.
Corporations, faced with lower profits and lower demand from consumers, scale back their investment in new products, technologies and manufacturing facilities. Fewer companies build new factories or spend money to develop the next-generation phone or computer. These scale-backs are usually the result of declining stock prices and expectations of continued declines in the stock market. When companies invest in a factory or develop a new automobile, they consider where the consumer will be two or three years down the road. Even heavy declines in stocks are not as damaging as slow, steady declines spread out over a long time, because heavy declines can reverse quickly.
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