How does stock market drop affect the economy if it doesn't affect the corporations?

Question

Sorry if it's a basic question.

Suppose corporation ABC went through public offering many years ago. ABC retained 30% of the shares, and 70% are being traded. The very initial offering, ABC made money. But thereafter, all the share trading and the associated money doesn't go to ABC, rather between the share holders.

How does a drop in share price due to trader fears (or an action ABC took) affect ABC itself? According to How can a company run out of cash when its stock prices is dropping? it does not affect the corporation.

Stocks usually don't affect the immediate operation of a company, since they are traded on secondary markets (stock exchanges) among stock owners.

So how does it affect the overall economy?

Answer 1

1. Companies don’t issue stocks once and for all. It’s one of their sources of financing. Even if a majority of stocks is traded on secondary market companies still routinely issue new stocks when they are in need of cash.

2. Stock owners may feel less wealthy if the stock values fall and hence they might spend less or postpone their consumption. People who were just to cash out, for example due to retirement, might decide to postpone that and lower their consumption until the market recovers. This is negative demand shock and it’s bad for the economy.

3. There is also reverse relationship. A stock price is basically derived from the discounted expected value of future profits that the company will earn. If the expected future profits are lower due to some economy wide problems stock market will pick on that. The causation there is exactly opposite - it’s not stock market that affects the economy it’s economy that affects the stock market. Often when policy makers talk about improving the stock market they actually talk about policies that affect companies profitability not about policies that target sellers and buyers on secondary market.

The above list is not exhaustive but it should give you some idea why there might be some relationship between how the economy and how the stock market is doing.

Answer 2

There’s quite a few pieces to the answer.

The first thing to keep in mind is that the prospects for the economy also drive beliefs about business profitability, as well as the willingness of investors to take risks. This means that expected weakness in the economy normally translates into lower stock prices. As a result, people can use the stock market as a measure for beliefs about economic growth.

However, there are a number of channels stock weakness can influence the economy.

• The market for new stock issues dries up, which might slow investment.
• Some investors borrow to buy shares, and falling prices forces them to sell to meet margin calls. This can feed into a financial crisis. (The 2008 Financial Crisis led to a strong contraction in growth.)
• The wealth of stock holders is lower, and they might spend less (known as “the wealth effect”).
• Undertaking activities like fixed investment and new hiring requires confidence in future revenue growth. That confidence likely falls in response to the stock market falling, since people are aware that the stock market can be used as an indicator of economic growth (as noted above).