Long-Term Economic Effects

The level of the stock market is very important to the economy. Both consumer purchasing and business investment drive the economy. We have already discussed the association between investor confidence and consumer purchasing. When investors lose confidence, they tend to purchase fewer big-ticket items and postpone buying a new car. A prolonged slowdown in consumer purchasing will slow down the economy as well.

However, a depressed stock market also affects business investment. To see this relationship, first consider the effect of a high stock market. Indeed, consider what happens when the market is overvalued, as it was during the bubble of the late 1990s. If a company manager thinks the stock price is overvalued relative to the true fundamentals of the firm, then he or she will be inclined to issue new stock. In other words, the stock can be sold at an inflated value. The company can receive more money for it than it is worth. Thus, it seems easy and cheap to raise capital when the stock is overvalued. ^[7] Corporations can issue new stock and use the capital to make business investments. Business investments are the equipment needed to conduct and expand business operations. Corporations buy trucks , machines, factories, computers, and other capital items. These purchases improve the economy.

Now consider what happens if the company's stock is perceived by the managers to be undervalued. If the firm wants to raise equity capital, it would have to issue new stock at a low price ”a price lower than the managers think it is worth based on the fundamentals of the firm. This seems like a poor deal. Thus, firms tend to issue less stock and, therefore, make fewer business investments when the stock market is low. Or, at least, firms take such actions when managers feel the stock market is undervalued. This relationship between the stock price level and business investment is particularly strong for smaller firms with good growth opportunities. ^[8] Larger firms have better access to other capital markets (like the bond market), and firms without growth opportunity do not need capital.

An example of the relationship between the stock market level and business investment is illustrated by the real (inflation adjusted) Gross Private Domestic Investment, a measure that the U.S. Department of Commerce uses to track the business investment made in the United States. The record amount of investment was $1.7 and $1.8 trillion in the quarters near the top of the stock market bubble in late 1999 and early 2000. Since then, business has dropped off to less than $1.6 trillion per quarter ”a decline of $100 billion per quarter. Consider also how the level of the stock market affects the ability of new firms to raise capital. During the height of the market bubble in 1999, a record 548 companies obtained capital through initial public offerings (IPOs). The first half of 2002 can be characterized by a depressed market with concerned investors. It is no wonder that only 46 IPOs were offered in the first six months of 2002.

Company executives are under attack for being loose with the books. Often, the public's perception is that executives are spending their time rebuilding profits and balance sheets. Executives must certify their financial numbers to the SEC and defend against a sustained media and political attack for misdeeds, and they are not spending as much effort on business expansion activities requiring new capital spending. Companies that sell products that support expansion ”like the hardware and software, respectively, of IBM and Siebel Systems ”report that they are seeing reduced sales and orders for their products. ^[9]

If the stock market is only temporarily depressed, it should not create a big problem for the economy. As argued above, the recent market depression is caused more by a lack of investor confidence than poor economic conditions. However, if the stock market remains depressed for long, it may begin to slow down the economy as well. The lack of investor confidence causes consumers to delay their spending. The lower stock market, caused by the confidence crisis, will eventually affect business investment too. With lower consumer purchases and business investment, the economy could sink into another recession . Therefore, it is imperative that investor confidence is restored quickly.