The Bailout and the Stock Market

One week ago, the House rejected the bailout bill and the Dow fell more than 700 points. That fall was a major reason why public opinion shifted from heavily against the bailout to confused, and why the bill passed on Friday. On Friday, though, the Dow fell another 150 points, and today at 1 pm Eastern it’s down another 500 or so.

Before panicking, though, we have to consider what this means. Broadly speaking, we are faced with two related crises, each of which is approximately represented by a different market. The first is a global economic slowdown that people have been talking about for months. The second is the acute credit crunch that hit after Lehman went bankrupt on September 15.

Fears of a global economic slowdown are reflected in the stock market. Stocks are claims on the future cash flow of companies, and companies do better during economic growth periods than during recessions. When sentiment shifts from the belief that we will see a short, mild recession to the belief that we will see a long, harsh recession, the stock market goes down. By contrast, the acute credit crunch is reflected in the credit market in the record-high prices that banks are charging to lend to each other and to ordinary companies.

Although you and I and most people with investments have more money in the stock market than in the credit market, the stock market is more a gauge of sentiment than an independent force in the economy. Lower stock prices make it more expensive for companies to raise equity capital, but most companies raise more money by issuing debt than by issuing stock. And when people’s investments go down, they tend to spend less, but only a little; if their 401(k) goes down by $10,000, they don’t cut back on spending by $10,000. The credit markets, by contrast, have direct and immediate effects on how companies behave; in an extreme case, no credit can mean no cash with which to make payroll. (See the posts tagged “real economy” for a couple examples of this.)

Now the credit and stock markets are related, because when the credit market freezes up, people’s expectations about the future turn downward, and hence stock prices fall. Ironically, all the attention the credit crisis has gotten over the last three weeks has undoubtedly hurt stock prices because of all the talk about potential dire consequences. (As Simon advised me, if you write a post entitled “your money is not going to go poof,” as I did, 20% of your readers won’t see the “not.”)

So in this context, what does the fall in the stock market mean? Probably two things. First, people are only beginning to realize that Europe is in big trouble – given its difficulty in coming up with coordinated economic policy, perhaps bigger trouble than the U.S. Because U.S. companies operate in a global economy, that will hurt all companies. Second, it means that more people are realizing that the Paulson plan is only a partial solution, which is something we (along with many other people) have been saying for a while.

As long as the credit market remains tight, fears of recession will remain high, and stock prices will suffer. The important question is when the credit market will loosen up. Right now it looks like there are still enough open issues with the Paulson plan (what price, which securities, how fast) that lenders are still waiting and seeing. In the long term, though, the stock market will only turn up when people believe there is a credible plan for fighting the recession in the real economy.

2 thoughts on “The Bailout and the Stock Market

  1. Thank you for helping me to understand better what is happening especially since the economic crisis has affected my retirement assets. I am retired and on the edge of panic. My kitchen and lav have been ‘demo-ed’ for renovation and I was hoping to draw on some assets for remodeling. Now the dilemma is to continue or stay in a holding pattern till things improve!
    Thank you for letting me have a comment.

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