With the intense focus on the stock market, it can be easy to forget that the market is one component of the economy; it's not the economy itself. It represents numerous economic players and entities, such as companies and pools of capital. A recession affects the companies whose shares make up the stock market, and it affects the people who invest in those companies' stocks. Psychology is as important as tangible effects.
Recession Hurts the Economy, Hurting Companies
A recession is a slowdown or halt to the economic growth of the country. This can lead to unemployment and lower spending by individuals and companies. All the factors in a recession are intertwined. For instance, unemployment is likely to increase as companies try to boost their margins -- when people spend less because of the increase in unemployment. The factors feed into one another in a declining spiral. Companies suffer from lower revenues, lower profits, and weaker growth in the future. All those factors come into play to determine the value of a stock on a fundamental level. As the companies' business suffers, so too does their stock price, leading the whole stock market lower.
Economic Malaise Erodes Investor Confidence
Even if a company is weathering the storm of a recession well, investors might not trust this to continue. Investors also might not trust the overall market, because the entire market tends to have a general trend, although a single stock might run counter to the trend because of exceptional circumstances. When the whole stock market is declining, individual stocks decline as well. It might be considered prudent to then move to a cash position and liquidate all investments. A resulting large-scale shift of money out of stocks can cause further stock market declines. The perception of a weak market can reinforce a weak market.
Financial Need Can Result in a Flight of Capital
The largest players in the market are institutions that might have capital pooled from numerous individuals. As a recession carries on, people might pull money out of the market to meet basic needs, especially if they are unemployed. Without a job, investment capital can quickly become savings. Fiscally conservative investors who lose faith in the stock market as a viable investment might abandon stock market investing. This is different than the temporary move to cash that can result from the expectation that the stock market will continue to decline for a while.
Spurring Government Action
Government stimulus packages and actions by the Federal Reserve Board can have an effect on the stock market during a recession. Federal stimulus programs can attempt to reverse the recession, although they might merely prevent it from worsening. A stimulus can help the market by giving an infusion of cash to individuals, local governments, and certain companies. On a wider scale, the Federal Reserve can institute bond buying to infuse capital into the economy to get money flowing. This can inflate stock prices while a recession is still raging. An example of this would be the boost the stock market got from "quantitative easing" -- the Fed's buying up of mortgage-backed securities to increase the money supply.
Nihar Patel covers finance and investing for several online publications, including Seeking Alpha. He also runs his own investment analysis website. Patel holds a J.D. from UC Hastings College of Law, as well as a bachelor's degree in political science and history from UC Davis.